Ask yourself, “Are my investments working to meet my financial goals and needs for each stage of life?” If you can’t easily say yes, then maybe it’s time to re-evaluate or create a written investment plan.
Why you need a written investment plan
One of the first steps to creating a personalized investment portfolio is setting return objectives and risk tolerances for each stage of life.
Let me give you an example. As a young college grad, you may be fairly risk adverse and willing to target higher returns and therefore higher risk. However, as you enter retirement, your return objectives are much lower and therefore your risk is much lower.
This principle is straightforward, but many investors don’t take the time to define their financial goals, return objectives, and risk tolerances for each life stage. The danger in not setting these objectives early is that (1) you can’t know if your investments are working to achieve your goals if you have never clearly defined what your goals are and (2) you may design a portfolio that exposes you to the wrong level of risk (could be either too little or too much risk).
So how many stages of life should you plan for?
You need to identify stages that entail unique financial requirements and goals. The average investor will have two life stages: earnings and retirement (though you many have others like semi-retirement). For each stage, you need to determine:
- The time period it will span
- Your age at the beginning
- What your life goals are
- Your financial needs to meet your goals
- And the financial instruments that are most likely to help you reach those goals
Setting portfolio objectives and structure
What’s your return objectives and portfolio structure for each life stage? This may seem like a straight forward question but truly poses many complexities.
First, identify the inflation adjusted amount of money that you need to have at the end of each life stage. For example, at the end of the earnings stage, I know that I’d like to have enough money in the bank to create an annual income of $50,000 in today’s dollars to live on each year.
The specific amount you use is up to you to determine.
There are many great calculators online to help you to figure out how much money you will need online.
- Start Farm retirement calculator
- CNN Money retirement needs calculator
- Another CNN Money retirement calculator
- Kiplinger retirement calculator
Second, for each identified life stage you need to determine the necessary rate of return on the amount of money you will be investing to reach your goals.
This si when a good handheld financial calculator comes in handy. Basically, you enter the amount of money you need at the beginning of a specific life stage (such as retirement), how many years between now and then, and your annual contributions.
The calculator will then spit out the rate of return that you need.
Remember that your rate of return is an average rate of return. For example, let’s say you need 8% each year. You can earn 0% one year and 16% the next year and that’s still 8% over the two years.
So don’t freak out if one year underperforms.
What’s your risk tolerance and benchmark indices?
Knowing how much you need to retire and the rate you need to earn will help you determine just how risk adverse or risk tolerant you need to be.
Just to be clear, risk does not mean anything negative. Risk is just the measure of a specific outcome, both good and bad.
If you need a high rate of return to achieve your financial objectives, then you have two options. First, increase the amount you are saving, which you should do anyways. And second, take on investments with higher risk.
Emotionally, many people can’t take on much risk. That means you are stuck with option #1 – invest more money. But if you can stomach it, then you should carefully evaluate higher risk investments.
Caveat – Don’t do anything stupid just because it’s promising big money.
As time passes, you will want/need to evaluate how your portfolio of investments is progressing. For that reason, select benchmark indices as a basis for comparison.
Example: If I’m investing in a bunch of large cap mutual funds, then I should compare my return to the S&P 500. But if I’m investing in small cap funds, then I should look at the S&P SmallCap 600.
This is just the start
A lot of work and research goes into creating a sound portfolio. But hopefully, this post gives you an idea of where you need to start.
If you have any questions, definitely consult a certified professional.
For everything else, follow Rabbit Funds on Twitter.
(This post was featured in the Carnival of Personal Finance hosted at Money Q&A)