We are continuously inundated by market predictions and investment prescriptions that tell us what to do with our hard earned money. But successful investing is not about following prescriptions. It is about achieving your goals, a process that starts by asking the right questions. In this blog we raise key questions for you and your financial advisor to consider when building your allocation to stocks and bonds.
This is the post most people have been waiting for: investing tips. You want me to share where I think financial markets are going or if I can help you find the next Google or Amazon. I get this question a lot, and It’s not surprising that people would ask. We have all heard stories about finding riches by beating markets, or discovering this small disruptive company that becomes Apple. That’s the sexy side of investing; it would be great if it happened to us, wouldn’t it. It is also the side the media likes to show. Reporters and financial ‘experts’ never fail to make predictions about markets or give investment prescriptions. And all too often, we may just fall for that.
So, what’s my answer? I don’t know of any secret gem or where the markets are going. I am not that kind of advisor. Why am I reading your blog then? You ask. Stay with me please. Let’s first clarify what investing is and what isn’t. Pursuing some hot tip with the hope of high returns quickly, or trying to predict from market gyrations is not investing. I call that speculating. Investing is about using your money and resources strategically to maximize the likelihood of achieving your goals.
The focus of my advice
So here is the focus of my investment advice: Helping you achieve your goals. If you are interested, keep reading. This post is the first in a series that will cover several aspects of our investment process. Today we talk about the first step, choosing the mix between stocks and bonds. Research shows this choice (called asset class allocation) is the main driver of performance across investors (94% of it). Security selection (4%) and market timing (2%) are much less important. So selecting the appropriate mix for your goals is a key to achieving them. Go through the questions below and write down your answers to get started!
What does success look like?
The first step in investing is to identify goals. Surprised? Try to achieve anything that requires planning, and experts will tell to set a goal. Sports, health, diet, school, career, you name it. Achieving goals is about delayed gratification, you have to give up something else today to achieve a goal. So it is important that you set a goal that is meaningful to you, as that will help you will stay on target when you encounter setbacks. You can use our free tool or other on-line tools, or talk to a trusted advisor to help you set your goals. Along with aspirational goals, like a comfortable retirement, children’s education, travel, etc, it is important to include other ‘risk management’ goals, like having appropriate insurance and setting funds aside for emergencies, like a temporary job loss. Your allocation should consider these other goals as well. Write down all your goals.
What is your time horizon for achieving the goals?
Clearly identified goals have a time horizon, like retire in 15 years, pay off my mortgage in 10 years, and so on. The time horizon affects one’s ability to take risks. We generally divide investments into growth opportunities, which include risky assets like stocks, and risk management assets, like bonds. The investment horizon is a key determinant of the appropriate mix between growth assets and risk management assets. All else equal, a longer horizon can justify a greater allocation to risky investments like stocks. There are two reasons for this. First, a longer horizon gives you more flexibility to make adjustments down the road if you encounter setbacks, like returns that are lower than expected. Second, statistically speaking, the likelihood that risky investments will grow (and not experience negative cumulative returns) increases with the time horizon. For each goal, write down their investment horizon.
How much risk can you take?
How much risk you can take in your portfolio depends on factors that are unique to you. Your ability to generate income, what economists call human capital, matters. What is the level and variability of your income? How quickly could you make up for lost returns by increasing your savings? How do you expect your income to change over the next few years? If your human capital is high, you have a greater ability to weather changes in the value of your portfolio in rough times, so you can take more risk. Are you a business owner? If so, you probably have a lot of your capital invested in the business, so you are facing a risk that is unique to you and that may be relatively hard to manage. This unique risk reduces your ability to take risks with your portfolio.
The interaction across goals can matter too. Do you have large expenditures planned in the next few years, like a new car, a down payment, or college tuition? Commitments like these can affect your ability to make up for lost ground in case of lower than expected returns, and therefore reduce your ability to take risks with your portfolio.
Some goals may have a dollar value, like a down payment or a bequest, while others may involve regular withdrawals from your nest egg, like retirement income. Value vs. income goals can affect your mix between stocks and bonds, and the type of bonds that are used to mitigate risk. Write down the answer to each question in this section.
Are you risk tolerant?
There is a psychological aspect to how much risk you can take. Do short term movements in the value of your savings affect you emotionally? Are they a source of anxiety? How would you feel if your investments lost 25% or more of their value? Would you consider taking the money out? Your attitude towards risk directly affects how much risk you can take in your portfolio. Because risk and returns are related, if you are averse to risk you may have to settle for lower returns in your portfolio. Therefore it is important to know your preferences for risk before you choose your asset allocation. Consider taking a free risk assessment from the University of Missouri to understand your psychology. At DESMO, we have our own risk assessment. Write down the results of your assessment.
What is the rate of return you expect from your portfolio?
Another question I like to ask people that seek investment advice is the average return they can reasonably expect from their portfolios over time. I often find that people don’t know how much broad asset classes like stocks and bonds can return on average over time, and many have expectations that aren’t realistic for the level of risk they are willing to take. Not surprising, given most people don’t spend their time evaluating the risk return tradeoffs of different combinations of asset classes. But raising and discussing the question helps set proper expectations that can help avoid drastic changes down the road. Write down your answer, and put it in perspective by comparing it with some of the charts about risk and returns on this page.
Other questions matter
What investment accounts will hold the investments? What is your tax situation? Are there restrictions in terms of investable assets due to preferences or type of account? Are there any unique circumstances that may impact your ability to make certain investments?
So, no easy prescription for you today, sorry. The questions I raised are all personal. So how can I even begin to prescribe an investment plan? My goal, which I think is more valuable than a simple prescription, is to get you started thinking about questions that can help you achieve your investment goals. Work through the questions. Talk to your advisor or talk to us if you need help working through them. Write down your answers, and keep them short, to about one or two pages total. These questions will help you decide the right mix of investments for you. They form what investment professionals call an investment policy statement (IPS). Your allocation to various investments should be consistent with your IPS. Go back to it and review why you hold your investments the next time markets don’t behave the way you were hoping. The IPS will work as a guardrail to help you stay the course!
So this is my first piece of investment advice to you: start by working on you IPS today!
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
