Retirement Guide 2011: Take control and winMay 26, 2011: 5:00 AM ET
You don't have to be a genius to retire in style. Just don't outsmart yourself. Here's how to master the basics, and prosper.
By Geoff Colvin, senior-editor-at-large
FORTUNE -- Isaac Newton, arguably the smartest person who ever lived -- he invented calculus and discovered the laws of motion and of optics -- was also an investor. In retirement at age 77, he bought shares of the South Sea Co., then sold them after two months at a 100% profit. Typical Newtonian genius -- except that two months later he bought back in, held on until that infamous early-18th-century bubble burst, and lost a fortune equivalent to $5 million in today's money.
You can view Newton's story in two ways. The pessimistic view is that if the smartest person of all time was a losing investor, then the rest of us are truly without hope. The optimistic -- and correct -- view is that successful investing isn't about intelligence; if it were, Newton wouldn't have lost a fortune. The rest of us do have hope of investing well and retiring comfortably, and if we have problems, they aren't for lack of smarts.
The investing blunders that most damage our retirement prospects aren't errors of picking the wrong stock or fund. They're much more basic: When we should take action early in our lives and start investing in something -- anything -- we typically do nothing; and later, when we have investments that we should patiently leave alone, we can't resist meddling, usually at exactly the wrong moments. Sitting still when we should act, and acting when we should sit still -- if we can avoid those two mammoth mistakes, we enormously increase our chances of retiring successfully. Fortunately, you don't have to be brilliant to avoid them. You just have to understand them.
Failure to act is a serious problem that's getting worse. During the recession two years ago, 35% of workers weren't saving anything for retirement; now 41% aren't, says the latest report from the Employee Benefit Research Institute. Of workers offered a retirement savings plan at work, 21% don't participate, up from 19% two years ago.
As self-defeating as such behavior seems, it doesn't surprise behavioral finance experts. The problem is what they call status quo bias: We're hard-wired to do nothing in most cases, even when the data tell us that's unwise. Partly it's caused by loss aversion, our deep-rooted feeling that avoiding the loss of $100 is much more valuable than gaining $100. Compounding the problem is the vast menu of available investing options, creating what behavioral economists call choice paralysis. You can't possibly understand all the alternatives, so you choose none of them.
Researchers are finding solutions. One is showing people photos of themselves altered to look aged. When 70-year-old you is unnervingly real, you become dramatically more likely to save. Don't have access to sophisticated digital photo technology? Merely setting a specific retirement date, even if it's decades in the future, increases your likelihood of saving.
The opposite mistake -- acting when we should do nothing -- is just as costly to our futures. The S&P 500 has returned an average of 9.1% annually over the past 20 years, yet the average equity investor earned only 3.8% annually over that period, says research firm Dalbar. That is, if an investor had bought an S&P index fund and then unplugged his computer and phone for 20 years, he would have done quite well. But because investors are constantly buying near the top and selling near the bottom, they wreck their performance.
The explanation is a stew of human tendencies. An important one is recency bias -- our habit of believing the future will be much like the recent past and stocks will keep doing what they've been doing lately. Another is regret avoidance, which leads us to follow the crowd; if things turn out badly, we feel much better knowing that we did what everyone else thought was smart rather than the opposite.
The good news is that, unlike Isaac Newton, investors today have access to myriad resources that can help us curb these self-destructive inclinations -- from 401(k) plans and IRAs to boost savings to financial planners to talk us out of irrational decisions. In the pages that follow, you will read analyses of long-term market trends and stocks that should benefit, insights from top investors, and even tips on where to retire. All of it is valuable information to assist you on your retirement journey. But to make it pay off, you first have to master the fundamentals.
Looking back ruefully on his investing experience, Newton said, "I can calculate the motions of the heavenly bodies but not the madness of men." Today we can largely do what he couldn't. We know the major mistakes that endanger retirement, what causes them, and ways to avoid them. Maybe you couldn't invent calculus. But by getting a few big things right, you can look like a retirement genius.
Fortune Retirement Guide 2011
- 5 stocks for a population boom
- 5 stocks for the world's new spenders
- 5 stocks for cloud computing
- 5 stocks for rising inflation
- 5 stocks with solid dividends