Last week’s article covered strategies for those getting a late start on investing for retirement. See For Those Getting a Late Start on Saving for Retirement.

That article primarily addressed finding money to invest. Assuming you have done so, this week’s article addresses simple strategies for converting that money into wealth.

Ground Your Expectations

First, let me offer some caveats. This is not a get-rich-quick scheme. This is long-term investing with an eye toward retirement. It is not gambling. I don’t recommend high-risk strategies — especially for those getting a later start. As you get closer to retirement, your approach should become more conservative.

There have been times when the stock market has suffered steep declines in various years. During the market crash in 2008, the S&P 500 Index — an index of the 500 leading publicly traded companies in the U.S. — fell more than 37%.

In fact, that decade was the worst in U.S. history. The decade started with the dot-com bubble and crash and then suffered through the housing crisis.

Nevertheless, the average annual return over that decade was only a loss of around 0.95% per year.

On the other end of the spectrum, there have been several decades in which the average annual return was close to 20%.

In the 1990s, the average annual return was about 18%.

Following the worst decade ever from 2000 to 2010, the average annual return of the S&P 500 from 2010 to 2020 was approximately 13.6%. This period was marked by a strong recovery from the Great Recession, significant advancements in technology, and generally favorable economic conditions, leading to robust growth in the stock market.

I say these things because you need to understand the downside risk while keeping in mind that over the longer term, the average annual return of the S&P 500 is around 10%. You certainly don’t want to take a 40% loss just as you are preparing to retire, but if you have a longer time horizon, you can invest more aggressively.

Before you start to invest, I recommend taking one more step.

Step 1: Establish an emergency fund.

This isn’t absolutely required, but I would recommend setting aside the first few weeks or months of your savings into an emergency fund. That will help keep you from dipping into the growing nest egg we will build in the next step. You should view that money as absolutely off limits and a little cushion in a savings account will help keep it off limits.

If you want to start investing right away, dedicate some portion of that investment to establishing this fund.

Step 2: Set up a mutual fund account that invests in an index like the S&P 500.

This is where the wealth-building takes place. The following strategy is “easy mode.”

If you find that you like being a more “hands on” investor or you want to explore more sophisticated wealth-building strategies, there are plenty of Investing Daily contributors who can help you identify promising individual stocks for your portfolio.

But if you would rather just invest broadly in the market and set everything on autopilot, this is the strategy I recommend.

Contact one of the major investment companies such as Fidelity or Vanguard. If you call Fidelity at 1 (800) 343-3548, ask for a prospectus to the Fidelity ZERO Total Market Index Fund (FZROX).

This fund has no transaction fees and no management expenses associated with it. The fund invests in all of the largest companies in the U.S. such as Microsoft (NSDQ: MSFT), Apple (NSDQ: AAPL), Johnson and Johnson (NYSE: JNJ), etc.

If you call Vanguard at 1 (877) 662-7447, ask for a prospectus for the Vanguard Total Stock Market Index Fund (VTSMX) (or something equivalent). It’s similar to Fidelity’s offering but entails a tiny 0.14% annual expense fee, which is the case with most mutual funds. This isn’t a fee that you pay directly; it is deducted over the course of the year.

The management fee on index funds is so small that I wouldn’t let that dissuade you from investing in Vanguard instead of Fidelity, but if you find a fund at a different company with a higher expense ratio (~0.5% or higher for an index fund), I would avoid it.

When you make the call, explain that your objective is to invest in a low-fee, broad-based index fund. Again, an index fund will spread your money across numerous stocks in the stock market. Historically, index funds outperform most actively run mutual funds.

Unless your time horizon is a bit longer, don’t let anyone steer you into an index fund based on the NASDAQ Index, which is heavy with technology companies and can experience more volatility (but also before long-term performance).

Step 3: Decide on the type of account.

You need to determine the kind of account you would like to open. You can open a regular account, but as it grows, you will owe taxes on your gains. As a result, I would recommend a Roth Individual Retirement Account (IRA) for most people.

If your Modified Adjusted Gross Income (MAGI) is under $146,000 this year as a single filer or under $230,000 if you are married and file jointly, individuals can contribute up to $7,000 a year if you’re under age 50 and up to $8,000 if over 50.

This money is post-tax income (i.e., you already paid income taxes on it), but the gains aren’t taxed. When you withdraw the money, you won’t pay taxes on potentially huge gains.

Alternatively, you can open a regular IRA account (or if your workplace offers a 401(k), you could take advantage of that). In fact, if your employer offers any sort of 401(k) contribution match, you should absolutely take advantage of this. This will jumpstart your savings.

The advantage of a regular IRA or 401(k) is that the money you contribute is pre-tax income, but you have to pay taxes later on all withdrawals.

Further, with both a regular and Roth IRA, there are penalties for withdrawing before you turn 59 and a half in most cases. That provides an incentive for leaving the money in and letting it grow. However, you can withdraw your original Roth IRA contributions (but not gains on investments) without penalty or tax at any time.

If you want to have penalty-free access to your funds at all times and are willing to pay the taxes as you go, just opt for a regular account. If you want maximum wealth-building and think you can leave the funds alone until you are 59 and a half, then opt for one of the IRA accounts.

There are many options. Explain your situation when you call, and they can advise you on the right account for you. If you can save a lot of money, you may want to maximize a Roth or regular IRA first, and then put the rest into a regular account.

Step 4: Automate the investments.

There will be an option to fund your account with periodic automatic withdrawals from your checking or savings account. Once you figure out how much you can comfortably save, this is the option you want to choose. That way, once it’s all set up, you don’t have to do anything except keep putting money into your savings account. It will be like another bill you pay, except you are paying yourself.

Step 5: Watch your wealth grow.

This is self-explanatory. Your wealth will grow over time. Resist the temptation to dip into it as it grows.

The long-term annual average return of the S&P 500 is 9.8%, but there’s no guarantee that’s what you will get. Year-to-year returns can vary enormously. There may be years that the fund falls by 40% and years that it rises by 40%. But over time, there should be more winning years than losing years, and your wealth will grow.

Don’t pay attention to the returns in the short term. Those annual ups and downs are noise. You don’t care about this year’s return; you care about what happens over the long term. If you can block out or just ignore that short-term noise, this is a winning strategy for wealth-building.

However, if you tend to panic and sell when the market is tanking, you will find it much more difficult to build wealth over time. In fact, that’s a strategy for shrinking your wealth, as people are notoriously bad at timing the market.

Final Thoughts

Good luck. It’s never too late to start. Saving something is better than saving nothing. But as you get closer to retirement, you need to shift more of your assets into cash and fixed-income assets with less downside risk. If you are 60 years old and planning to retire in five years, under no circumstances should you have all your assets in the stock market.

A conventional guideline for determining the appropriate portfolio allocation is to allocate a percentage towards equities (stocks) equal to 100 minus your current age. Thus, at 60 years old, you would have 40% of your portfolio in stocks.

Keep in mind that one size doesn’t fit all. There are valid reasons you may want to increase or decrease this percentage — as long as you are certain you have a good safety net protecting your downside. I don’t strictly follow this rule myself, but I am also well-versed in the risks of such an approach.

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