Planning for the future can be a daunting task but it's never too late or too early to start. I've talked about the importance of defining and identifying the steps to create Financial Freedom, the importance of Investing and Investment options for the average investor. Whether you're debt free or working on getting out of debt, planning for the future inevitably yields rewards that are incalculable. Now that personal finances have taken a front seat in my life, I pay closer attention to conversations I have with people to glean a better understanding of their perspective towards money and investing.
Some of the reactions I've heard from personal friends about investing was the driving force to starting this blog. I wanted to help educate the people around me to make smarter decisions so they can change their own money tree. I've heard friends say things like "I haven't started a college fund for my kids yet because 529's aren't FDIC insured" OR "I've been doing research on college planning and I think I'll be fine with a regular mutual fund vs a 529 plan" OR "I want to invest my money but I can't risk losing anything" OR "I want to save $150,000 before I feel comfortable with investing". I understand the general fear with investing because just about a year ago, I too was afraid of risking my hard earned dollars. I did some research and I learned a few things that helped me understand the right approach to investing. This article is dedicated to my friends and anyone else, who for one reason or another has allowed fear to sideline them.
The first rule of thumb is to ALWAYS keep about 6 months of expenses in cash reserves. Cash reserves are short term investments with low rates of return that are held in checking accounts, CD's, savings and money market accounts. This money should NEVER be invested.
IDENTIFY YOUR GOALS
What are you saving for? Retirement? A Kid's College Fund? A House? A 3 week vacation in Italy? Categorizing your short and long terms goals serve as a road map to making the best money decisions. Saving for a house or a vacation would fall under the short-term category while retirement and college are under the long-term category. The distinction between short and long term goals determine your Investment Time Horizon. Your time horizon is measured by the amount of time you have from today until your reach your savings goal. Short-term goals are those that are within 5 years of reach, intermediate goals are from 5-10 years out and long term goals are those that have a time horizon 10 years and greater.
DH and I don't have any short-term goals besides paying off debt. Our long term goals include college and retirement planning. We started our son's college fund when he was 5 months old and the time horizon for this investment is about 17 years. Our time horizon for retirement is another 20-25 years depending on when we decide to retire. If your goal is save and buy a house in the next 3-5 years, this would be considered a short time horizon, rendering investments in securities a NO GO because you simply wouldn't have enough time to recoup losses in the event of a market downturn.
RISK TOLERANCE & RISK CAPACITY
Your investment time horizon dictates your Risk Tolerance, which is the level of market volatility you can tolerate. Risk tolerance is all about your emotional reaction to market swings. Are you more inclined to take on more risk for a more favorable outcome? Can you withstand losses without panicking? When the market crashed in 2009, people who were heavily invested in stocks saw declines as high as 50% in their portfolio. They panicked and reacted on emotion and sold, which effectively locked in their losses. This is a classic example of a portfolio that is misaligned with risk tolerance. As stated above, a friend of mine didn't start a college fund yet because she wants some type of guarantee on the money, which indicates a very low risk tolerance.
Risk Capacity is the amount of risk you can "afford" to take on in order to meet your financial goals. If you're 30 years away from retirement and have a high risk tolerance (having mostly stock in your portfolio) then a market crash will not jeopardize your investment objectives because you're years away from having NEED for the funds. If you're 4 years away from retirement, your risk capacity will be low because you can't "afford" to lose much money and you would adjust your portfolio away from stocks to include safer investments. As it stands today, I have my emergency fund in place, retirement is at least 20-30 years away and I'm looking for high growth...therefore my risk tolerance and risk capacity are both high. If the market sinks tomorrow, I will make no changes to my investments except to hunker down and take advantage of low prices and buy more.
Your risk tolerance and risk capacity will determine your asset allocation, which is strategy geared towards balancing risk by distributing funds across a set of assets according to your goals, time horizon and risk tolerance. In other words, it's a collection of your investments across various asset classes. The 4 main asset classes are Stocks, Fixed Income or Bonds, Cash Equivalents, Real Estate or other tangible assets (Read more about these HERE). The average investor has at least 3 or all 4 of these elements in their portfolio. What varies from person to person is the % of each category in the portfolio. Within a portfolio an investor can be exposed to many different sectors like Retail, Health Care, Energy, Technology, Financials etc, if invested in a stock mutual fund. Mutual Funds provide broad sector diversification and limit your exposure to risk associated with one particular sector.
A 30 year old investor with a high risk tolerance and risk capacity can easily have an asset allocation of 80% stocks and 20% bonds. Bonds are recommended because they offer protection when stocks are plunging. When the 30 year old advances in age to 55, they would probably want to re-balance their portfolio and shift to a more conservative allocation of 60% stock and 40% bonds. Your asset allocation is based solely on the level of risk you can tolerate and the length of time you have before needing that money.
THE COST OF HAVING TOO MUCH CASH
For my friends who allow fear to continue to sideline them from investing, consider that too much CASH is a DRAG. In addition to investing for retirement, you should aim to invest all personal cash above your emergency fund. We've established above that emergency money should be kept in safe low risk accounts. Keeping any money above the designated amount for emergencies, is futile. Why? For every $10,000 you keep above what's needed in a money market account that returns 5% less than a long-term investment, you lose $500 every year it's kept there.
COST OF INFLATION
We've all heard the term "inflation", which refers to the increasing cost of goods and services while the purchasing power of your money declines. Experts estimate the rate of inflation at about 3% annually. That means that what $1,000 can buy you today, will cost you roughly $1,060.90 by the end of 2018. Excess liquidity (large amounts of cash not invested) means time spent out of the market, which carries the high cost of inflation. Let's not forget that those excess funds are gaining about .01% interest in your local bank.
Let's sum up the takeaways:
- Keep an emergency fund liquid in checking, savings or CD. Never invest this money
- Identify your short and long term financial goals
- Money for short-term goals should NOT be invested
- Money for long term goals greater than 10 years SHOULD be invested
- Know and understand your risk tolerance and risk capacity
- AUTOMATE: If you've already met your short-term goals, set up automatic withdrawals from your brokerage account to buy more shares of your investments. Remember the key is to make excess dollars make more money for you.
Investing isn't only for retirement but everyone should consider having their personal savings working for them. If you want more information to determine your your risk tolerance, I suggest using Vanguard's Investor Questionnaire.
Are you ready to overcome your fear of investing? What's your general feeling with investing your personal savings? Drop me a comment below.