In my last newsletter, I promised that I would take you through the orderly steps required to establish and maintain an investment portfolio. This newsletter will consider the first step in the process : Determine your investment goals. How are you going to get somewhere if you don't know the somewhere you're trying to get to? I mean, would you just hop in a taxi and tell the driver, "Here's 20 bucks, just take me wherever you're going and step on it!." That wouldn't make any sense. The cab driver would be glad to take your money, I'm sure, but you would only get nowhere fast. The point is, if we're going to be saving our hard-earned money and forgoing the pleasure of spending it now, we should have a well-defined goal for those savings. But setting our financial goals also does something else for us. It determines the time frame we are looking at to accumulate the necessary funds for our goal. This in turn help us to determine how we are going to put the money that we save to work for us, that is, how we are going to invest it.
For example, if your goal is to save $30,000 for the down payment on a new home in 5 years, you wouldn't want to invest the money in an aggressive growth stock mutual fund. Your potential rate of return will be greater than putting your money in a bank savings account, but the risk is all out of proportion for this particular goal and time frame. Let's say the mutual fund into which you are making your monthly deposits of $500 has the following rates of return for the 5 years:
Amount Accumulated
Year 1: 10% $6,600
Year 2: 25% 15,750
Year 3: 7% 23,272
Year 4: -10% 26,945
Year 5: -15% $28,004
Although the fund had great returns in the first 2 years of your savings plan, the 2 lousy returns in the final 2 years has left you a little short of your goal. That's the problem with using riskier investments for short term gaols. If we would have instead deposited our monthly savings in a savings account or money market mutual fund earning a 1% return, we would have accumulated $30,809 with very little risk. I will concede that a 1% return that is reflective of our current economic environment provides a pretty lousy return compared to rates on savings accounts and money market funds in the not too distant past, but we have to work with the tools currently at our disposal.
If we have a longer time period in which we can save for a goal, for example, retirement, then a mutual fund such as an aggressive growth fund could be appropriate for a portion of our investment portfolio. I emphasize the word portion because, no matter how young you are when you begin accumulating a retirement fund, financial planners generally recommend that you also have some less risky and non- correlated asset classes in your portfolio, such as bonds. The point is, with a longer time frame you have time to recover from a few bad years of returns before you will need to withdraw the funds, so you can afford to take on riskier investments that potentially provide a greater return. Since stocks have in the past 50 years or so provided a greater return than bonds, then you will want to include some stocks in your portfolio for long term investment time frames, or as they like to call it in financial planning circles, longer time horizons.
Similar goals will present different time horizons depending on our individual circumstances. For example, if you have two children and one of them is 5 and the other is 12, you will of course have two different time horizons and therefore will need to select investments appropriate for each time horizon. In either case, as the time for starting college approaches then you will want to increase your bond portion to decrease your risk exposure so that the funds will be available for college costs. Another example would be retirement saving. A 30-year old and a 50-year old person obviously have different time horizons and so the types of investments and percentages in the respective portfolios appropriate for each person would be different.
Most of us have several financial goals that we need or want to work toward so it stands to reason that we will have more than one investment portfolio. For example, one portfolio for retirement, one for college savings, one for a major purchase, and so on. We could think of all of our investments as one portfolio and each specific goal could have its own sub-portfolio. I know some of you are thinking that that sounds complicated and I'm preaching simplicity, but if you think of your finances in terms of goals, as you should, then it follows that different goals will require different types of investments. Just think in terms of something that is easy to relate to....pie. We have all seen pie charts and they are pretty easy to understand. A simple pie chart could be just 2 slices, or a pie cut in half if you, for example, have 50% of your money in bonds and 50% in stocks. More than likely in your portfolio you'll also have other types of investments, so, for example, if you have 15% invested in a money market account, 10% in cash, 25% in bonds, and 50% in stocks, you would have a 4-slice pie with each slice proportionate in size to the percentage of each investment type. So with multiple goals you will have several "pies", all sliced up differently and with a different set of ingredients. And hopefully, with time and the great American economy on your side, your investments will have grown to meet your goals so that by the time your pies are ready to be served up, they will be very, very filling.
The bottom line: Setting specific investment goals is the first step in developing a successful investment strategy. You can do it! It's as easy as pie!
Next newsletter: Step two in developing an investment portfolio-Writing out your investment policy statement.
Wishing you the best,
Randy
randy@mooreadviser.com
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