Most investors, and even some advisers, do not understand the difference between active and dormant accounts. But knowing how to invest in each is paramount to having a successful retirement.
In an active account, such as a 401(k), 403(b) or individual retirement account, you’re still buying assets and contributing regularly. When the market goes down in value, you probably don’t like it, but you don’t worry excessively because you’re still buying shares, and you can get them at a lower price. That helps you recover more quickly when the market goes up. Buying mutual fund shares regularly in an active account can be appropriate for some investors because you can take advantage of the volatility.
You generally want to avoid mutual funds in a dormant account, however. A dormant account is any account that you are not putting money into on a monthly basis; or even less ideal, an account from which you are withdrawing money. Both stock and bond markets are volatile, and the fee structure of a mutual fund acts like an anchor over time on dormant account. When the market goes down in value, you are going to lose money, and you will not be using the volatility to your advantage. Instead you have to wait and hope that the market recovers.
For example, let’s say your lifestyle needs require you to take out 5% annually from the $1,000,000 in your account, or $50,000. If you continue to do so when your account total has dropped, the amount you withdraw can never go back up in value. It’s gone. You don’t recover from that type of scenario. That’s why it is typically inadvisable to depend solely on an account that fluctuates with the markets to provide you with retirement income.
Still, I meet with people every day who have dormant accounts that are 80% or 100% invested in mutual funds. In most cases, it’s a scenario that isn’t working well for them. Over the last 10 years, it hasn’t been a good approach, in my opinion, nor do I see it as an appropriate strategy for the next decade.
Put another way: If you have one dollar invested in a stock market index, and the market crashes, losing 50% of its value, your dollar will be worth 50 cents. If you sit tight and the next year the market rallies, gaining 50%, do you have your dollar back? No, you have 75 cents. You’d have to have a return of 100% to offset the 50% loss.
Once your account goes dormant, you’re better off investing in assets that will not lose value due to market volatility. Examples include certain annuities (fixed and indexed), certificates of deposit or exchange-traded funds with a stop-loss attached to it. Whatever type of investment you prefer, the most important thing is that you avoid volatility.
Consistency is what counts when you’re retired and relying on a dormant account for income. If you get a 10% average return on your money, that can actually outperform a 25% average return.
Let me go over an example of how it works: Say that you put $100,000 in a potentially volatile investment—perhaps someone convinced you that in the long run you would be fine. The first year it works well for you: You chose the right initial public offering or technology stock and got a 100% return. You now have $200,000. You’re happy, so you do it again, and in the second year, because of a market correction, you lose half the account value. You’re back to $100,000. It went up 100%, but then it went down 50%. On average, your return over the two-year period is 25%—but in reality, you know you haven’t gained a cent. And when you enter fees into the equation, it makes the situation even worse.
Now let’s say that you don’t want to take a whole lot of risk, and you look for more consistency. So you put your $100,000 into an account, and the first year you get a 10% return. Your $100,000 is now $110,000. The second year you invest the same way and get another 10% return. You now have $121,000. The average advertised rate of return on that investment is 10%. The other accounts advertised average rate of return is 25%, but the account that averaged 10% is worth more money.
It’s the volatility, therefore, that can destroy a retirement. You need consistent, predictable, and all-but-guaranteed results when the account must support your lifestyle for the next 10, 20 or 30 years. It’s all really very simple math. It’s the way that the numbers shape up through consistent returns year after year after year. It’s a wise strategy that can allow you to live more boldly in retirement.
Article created by Kiplinger