I hope the new year is off to a good start for everyone.
This month’s edition of Financial Planning Tips focuses on investing basics. With the recent volatility in the financial markets, many people have become fearful about their investment portfolios and what the future may hold. Here are a few key investing considerations, and below is some additional information and guidance on two important pillars of investing: saving and investing wisely and asset allocation.
SPEND LESS THAN YOU EARN and invest the difference!
Then reinvest until you achieve your goals
Make this a must in your life; don’t give yourself a choice
Find the right asset allocation for you, and stick to it!
Asset allocation matters much more than selection of specific investments
Keep it simple, and avoid investments with high fees
Rebalance your portfolio at least once a year
Resist the temptation to react emotionally to market swings. Research shows that people who allow their investing decisions to be driven by emotion (especially fear) end up with subpar investment returns, as the temptation is to sell when the market is declining, then buy when things turnaround. Often this results in “selling low” and “buying high”, and thus locking in losses. Often a better strategy is to ride out market volatility, and stick to your plan!
See below for additional information/guidance on saving and investing and asset allocation.
Note that planning tips and other info. are now posted on my website, https://truenorthfinancialplanning.com/, under Resources/Blog. Feel free check it out.
Best wishes to all for an abundant new year!
Saving and Investing Wisely
Saving builds a foundation
The first step in investing is to secure a strong financial foundation. Start with these four basic steps:
Create a “rainy day” reserve: Set aside enough cash to get you through an unexpected period of illness or unemployment–three to six months’ worth of living expenses is generally recommended. Because you may need to use these funds unexpectedly, you’ll generally want to put the cash in a low-risk, liquid investment.
Pay off your debts: It may make more sense to pay off high-interest-rate debt (for example, credit card debt) before making investments that may have a lower or more uncertain return.
Get insured: There is no better way to put your extra cash to work for you than by having adequate insurance. It’s your best protection against financial loss, so review your home, auto, health, disability, life, and other policies, and increase your coverage, if needed.
Max out any tax-deferred retirement plans, such as 401(k)s and IRAs: Putting money in these accounts defers income taxes, which means you’ll have more money to save. Take full advantage if they are available to you.
The impact of 3% yearly inflation on the purchasing power of $200,000
To try to fight inflation
When people say, “I’m not an investor,” it’s often because they worry about the potential for market losses. It’s true that investing involves risk as well as reward, and investing is no guarantee that you’ll beat inflation or even come out ahead. However, there’s also another type of loss to be aware of: the loss of purchasing power over time. During periods of inflation, each dollar you’ve saved will buy less and less as time goes on.
To take advantage of compound interest
Anyone who has a savings account understands the basics of compounding: The funds in your savings account earn interest, and that interest is added to your account balance. The next time interest is calculated, it’s based on the increased value of your account. In effect, you earn interest on your interest. Many people, however, don’t fully appreciate the impact that compounded earnings can have, especially over a long period of time.
Let’s say you invest $5,000 a year for 30 years (see illustration). After 30 years you will have invested a total of $150,000. Yet, assuming your funds grow at exactly 6% each year, after 30 years you will have over $395,000, because of compounding.
Note: This is a hypothetical example and is not intended to reflect the actual performance of any specific investment. Taxes and investment fees and expenses are not reflected. If they were, the results would be lower. Actual results will vary. Rates of return will vary over time, particularly for long-term investments.
Compounding has a “snowball” effect. The more money that is added to the account, the greater its benefit. Also, the more frequently interest is compounded–for example, monthly instead of annually–the more quickly your savings build. The sooner you start saving or investing, the more time and potential your investments have for growth. In effect, compounding helps you provide for your financial future by doing some of the work for you.
Note: Asset allocation and diversification don’t guarantee a profit or insure against a loss. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, account for most of the ups and downs of a portfolio’s returns.
Deciding how much of each you should include is one of your most important tasks as an investor. That balance between potential for growth, income, and stability is called your asset allocation. It doesn’t guarantee a profit or insure against a loss, but it does help you manage the level and type of risks you face.
Balancing risk and return
Ideally, you should strive for an overall combination of investments that can help to minimize the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let’s say you want to get a 7.5% return on your money. Your financial professional tells you that in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there’s no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start.
Many publications feature model investment portfolios that recommend generic asset allocations based on an investor’s age. These can help jump-start your thinking about how to divide up your investments. However, because they’re based on averages and hypothetical situations, they shouldn’t be seen as definitive. Your asset allocation is–or should be–as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. You should make sure your asset allocation is tailored to your individual circumstances.
Many ways to diversify
When financial professionals refer to asset allocation, they’re usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you’ve got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don’t necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio.
Even within an asset class, consider how your assets are allocated. For example, if you’re investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies, or allocate based on geography. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held.
Monitoring your portfolio
Even if you’ve chosen an asset allocation, market forces may quickly begin to tweak it. For example, if stock prices go up, you may eventually find yourself with a greater percentage of stocks in your portfolio than you want. If they go down, you might worry that you won’t be able to reach your financial goals. The same is true for bonds and other investments.
Do you have a strategy for dealing with those changes? Of course you’ll probably want to take a look at your individual investments, but you’ll also want to think about your asset allocation. Just like your initial investing strategy, your game plan for fine-tuning your portfolio periodically should reflect your investing personality.
Even if you’re happy with your asset allocation, remember that your circumstances will change over time. Those changes may affect how well your investments match your goals. At a minimum, you should periodically review the reasons for your initial choices to make sure they’re still valid. Also, some investments, such as mutual funds, may actually change over time; make sure they’re still a good fit.
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Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2019.
Thomas C. Dettre, CPA, MBA
President and Founder
True North Financial Planning, LLC