Setting a Strong Foundation for Financial Success
Last fall, how many of you were preparing to protect your investments because of the war in Ukraine that came this February? Exactly. The point I’m making is that, as humans, we spend a lot of time worrying about things that don’t ever occur and it’s impossible to predict the future. Sometimes, things we don’t control so occupy our thoughts that we forget to take care of the things we do control. We don’t control events that may create volatility in markets, and we don’t have control over how markets perform. We do have facts that show that historically, stocks have provided a return that outpaces inflation over longer periods of time and that bonds have lower rates of return than stocks but provide cash flow and less volatility than stocks. So, what can we control? We have control over protecting our assets and we control, to some degree, our spending and consumption.
Let’s start there. How can we protect ourselves and our investments?
Before we even get to investments, let’s first address a basic level of protection. In the investment world, risk is defined as levels of volatility in markets but most people I meet are worried about permanent loss of capital. With a diversified portfolio of investments, we reduce the chances of permanent loss. But permanent loss can result from other circumstances such as identity theft, online scams, or fraud. The best way to protect yourself from scammers and fraudsters is to protect your passwords and to educate yourself on how these scammers operate. There is plenty of literature available to educate all of us about the way scammers will try to get you to release your private information to them. For password protection, you could look at software programs such as LastPass and for education on cyber-security, our IT consultants suggested Cyber Security for Beginners offered at Udemy.com.
When we think of the term “financial security”, my guess is that many of us think of asset allocation or new investments or IPOs that can make us a lot of money quickly and bring us to a state of financial freedom. Many whom I meet focus on rates of return without having first explored their own tolerance for risk or what level of return they need to achieve that which they are trying to accomplish. I think that the priorities should be the examination of risk tolerance, clearly defining objectives and goals, and finally, building an investment strategy that maximizes our chances of achieving those goals.
Risk tolerance and risk capacity
We start with the exploration of risk because it is fundamental to understanding how you will react under different market circumstances. We understand that one of the ways to minimize market risk is to diversify but too often, investors, in focusing on only the returns, overly-concentrate in that which is going up now. On the downside, investors may get nervous and sell at an inopportune time. Knowing what your tendencies are before a market event will help you to make rational and informed decisions. Markets are inherently volatile.
There’s another risk measure that you should consider which is risk capacity. Your risk capacity represents the amount of risk you are theoretically able to take based on when you need to use your funds. If you have a period of greater than 10 years before you need to use your funds, your risk capacity is high, and you can theoretically take on greater stock exposure because over time stocks tend to have less volatility than they do over shorter periods. If you need funds in the short term, your risk capacity is low, and you may want to avoid stocks because the stock market can be quite volatile over short periods. Risk capacity helps the investor to frame the possible asset allocation that could be applied in their situation.
Objectives and goals
Your objectives and goals are another critical part that will inform you about the investment strategy to consider. It is why you are investing in the first place. You are trying to make your investments grow presumably to help you to do something. Not clearly defining what you are trying to accomplish can lead to poor investment decisions. You should be able to quantify how much money you will need and when you will need it to accomplish your goals and objectives. Putting together your level of savings with the level of need over time allows you to determine the approximate rate of return you will need on your savings. Having that rate of return assumption informs you about the asset allocation that gives you the best probability of achieving what you set out to accomplish.
Once we understand our risk tolerance, risk capacity and the rate of return that we need to achieve, we can build an investment portfolio that maximizes our chances to successfully achieve our goals. Many of us are attracted to the investment process because of the excitement and promise that it can bring. However, if you can be patient and first work through the risk measures and the analysis of goals and objectives, you’ll better understand what you need to accomplish and increase the chances that you’ll achieve what you are trying to achieve.
Written by Bob Len, Managing Director