This article discusses when you need to decide how to invest your savings and when the times comes to leave money maturing and when the times comes to draw it from your investment for your retirement.
If you invest in bonds, IRAs or traditional 401k, whether by buying individual bonds, or by investing in any type of any other investment, and if you have more than one pension plan, then you have a portfolio of investment that can give you good returns on the money. The first part of this series of articles will discuss a number of strategies that can be used to maximize total returns safely. The second part of the series of posts will discuss how much of your portfolio you might want to allocate to investments in bonds or any other vehicle of retirement accounts.
Any investment for your retirement ought to start with a number of questions:
What is the ultimate use of the money? Am I saving for a specific need, for example, to fund my son’s college education? When will the money be used? Can I afford to lose any part of my investment?
Should the money be in taxable or in tax-exempt investments? Professionals have developed strategies that can be adapted by individual investors in the management of their own portfolios. These are discussed below.
WHEN WILL I NEED THE MONEY?
Assume that you are saving for a specific use (for example, to buy a car). If the money is needed within a fairly short amount of time, say two years or less, then your best option is to confine your choices to securities whose prices do not fluctuate. That limits you to money market funds, CDs, or short-term instruments such as T-Bills, even though, as this is being written, that means in all likelihood that you will earn literally almost nothing or well under 1% a year, annualized.
You might wonder why it is not advisable to buy longer-term bonds with higher yields and enjoy these yields until you need the money. There are two reasons. First, you cannot be certain that you will recover the entire principal when you need it because you do not know where interest rates will be when you want to sell. Also, as it will be explained in future articles, commission costs are particularly high when you want to sell or draw the money from your investments, particularly in the less liquid sectors of the market. Brokers will tell you that individual investors get killed by commissions when they sell.
“Maturity Matching,” or the “Bullet Portfolio”
However, if the intended use goes out somewhat further in time, say between two and ten years, then you have a different alternative, which professionals call “maturity matching.” (This is also called a “bullet” portfolio.) You would buy a security which will mature at the time principal is needed. For individual investors, typical intended uses include saving for a vacation, a car, or a child’s college education; in short, any objective where you can anticipate needing a certain amount of money, and you know when the money will be needed.
Open for example a IRA or 401k that will mature at the time the money is needed enables you to go out further along the yield curve and therefore to buy financial products that are higher yielding than the shortest cash equivalents (assuming a normal upward-sloping yield curve). This structure also eliminates the risk that principal will have declined in value if interest rates rise prior to the time that the money is needed.
A bullet portfolio does not dictate which instruments you should choose. If, for example, the money is needed in five years and you have invested it in physical gold, you might buy a five-year Treasury note, a five-year pre-refunded municipal bond, a five year bank CD, or a five-year Treasury zero. If rates seem particularly attractive (that is, high), then the zero is an attractive option since it eliminates reinvestment risk.
Another alternative for longer term investors with very large portfolios would be to use what is known as a “weighted maturity” structure. The basic idea behind such a structure is that a variety of maturities are selected. But generally, you would choose a combination of maturities whose duration is close to the expected target date when you would use the money. This protects your portfolio against a major erosion of the value of principal. And weighting the maturities enables you to take advantage of attractive buy points in the yield curve. One possibility, for example, would be to overweight the maturity sector that corresponds to the time the money is needed. Or an investor requiring the highest possible level of income might want to overweight both long-term bonds and pre-refunded shorter bonds. Variations of this strategy are discussed below.