Investing is a personal thing. What would be a suitable investment for one person’s retirement plans might be too risky or too conservative for another person. The best investments for you should meet your cash flow needs, mesh with your risk tolerance, not heat up your risk exposure, work well with your tax situation, and complement your other investments. Designing the right investment plan is not an easy task. College Station investment manager, Wm. Jene Tebeaux, CFP®, CFA® ,CAIA® of Paragon Financial Advisors, explains the crucial aspects to consider when setting up an investment plan and choosing your investments. He uses the following tier concepts with his clients.
Tier 1: The Baseline
Tebeaux tells us that first you need to adequately define your goals and objectives. For example, in retirement how much income will you need? To do this, think about what you want your lifestyle to look like in retirement. If you are not already retired, when do you want to retire? How much do you want to spend every year to support your lifestyle? Start by looking at how much you spend now. Make adjustments for changes you expect to experience after your retirement. Will you move? Will you travel?
Your end result should look like this: I want to retire in 20XX with an income level of $Y after paying income taxes.” Don’t forget to account for inflation in later years; it has historically been around 3%.
Tier 2: Four Equal Components
Know how your cash flow relates to your investment needs. Ask yourself, will you depend on income from your investments to afford your target lifestyle, or do you have extra money each month to save or invest? Investment planning during retirement is not the same as investment planning for retirement.
Consider your tax issues. Are your investments going to be mostly in your IRA or other retirement account? Income earned in these accounts will be taxed at ordinary income tax rates when you take the money out. Under certain circumstances, you could pay more. Your mix of pre-tax accounts and non-retirement accounts will affect your investment choices. Other considerations are your estimated estate taxes.
Understand your two kinds of risk – risk exposure and risk tolerance. Tebeaux defines your risk exposure as “the risk you have that can turn around and bite you and you may not even know what it is.” Risk tolerance is one of the fundamental issues to consider when planning your investment strategy.
Investment advisors commonly use risk tolerance questionnaires. The answers help clients understand their own ability to stomach the ups and downs of the stock market over time. The questions are varied. Here is one example: You are on a TV game show and can choose one of the following. Which would you choose? (a) $1,000 in cash (b) 50% chance at winning $5,000 (c) 25% chance at winning $10,000 (d) 5% chance at winning $100,000. There are no correct answers and no grade because everyone’s risk tolerance is different. Your tolerance for investment risk is influenced by both your goals and your personality.
Look at your existing investments. How well do you understand your own investments? Create a list of the investments you already own. Analyze them for both kinds of risk. Quantify whether they meet your cash flow needs. Determine whether they are the best fit for your tax situation. Know to what extent they are diversified.
Tier 3: Selecting Investments
This step involves spreading your investments over a variety of categories, such as equities, cash-like investments, bonds, real estate, foreign securities and maybe collectibles and precious metals. How you allocate your investments over these categories is determined by the components in Tiers 1 and 2 above. This allocation is called asset allocation. It is a method to help manage risk. It is not a guarantee of profit or protection against loss in a declining market.
Tier 4: The Monitoring Process
Once you have decided on your asset allocation, don’t think you get to sit back and relax. What was an appropriate asset allocation yesterday may not be right for you today. What is right for you today may not be good for you next year.
Tebeaux warns us to continually ask ourselves two questions:
How is my investment performance doing compared to its peer group?
Is my investment driving towards my goals & objectives?
We must keep asking these questions because factors change. You can have changes in your own investment objectives and priorities. Economic changes will mean changes are appropriate for certain kinds of investments. Growth or decline within investment classifications may require changes in the overall mix of your investments.
Tier 5: Estate Transfer
Consider whether your investments will help you turn your intensions into action. Will your investment management have continuity? Will there be protection for your beneficiaries? Will your assets go to the heirs of your choosing? Do you have a contingency plan if you become physically incapacitated? You should review these questions periodically because major changes in your investments or life circumstances can affect your estate plans.
Warnings to the DIY (Do It Yourself) Types
If you are trying to do all this by yourself, be aware of common mistakes.
Skimping on goals and objectives. If not held to a higher level of quality, most of us will cut corners on establishing goals and objectives.
Nostalgic investing. Despite the common knowledge that investing is best dealt with using reason and not emotions, many people insist on keeping investments for sentimental reasons. Stock is not an heirloom bracelet to be lovingly kept in the family. Ask yourself whether you would buy the stock today. If your answer is “No,” then why are you holding on to it?
Avoid management nightmare. We all know that diversification is a good investment concept but using the buckshot approach is not really diversification. In my business, I see divorced clients’ investment portfolios. Too many times their investments are scattered over four different brokers and two different banks. They only think they are diversified; if fact, they often have similar investments across different institutions even though they have tried to diversify.
Look under the hood. Tebeaux has seen DIY investors wind up in real trouble because they didn’t fully understand their investments or their associated risks.
Many people never attain the financial independence they want, because they procrastinate. They think investing is too risky, too time consuming or two complicated. Educate yourself and get started toward achieving your financial goals.