One of the primary issues people have with investing is realistic goal setting. They say “I want money to pay for my kids’ future school, oh but I want to have money for a nice vacation too!” My answer is that neither goal is more prudent than the other. What really matters is understanding these various goals and planning for them. Perhaps you will open a 529 plan to divert funds directly via direct deposit AND you will invest in an aggressive portfolio that offers a cushion for vacations. Set your goals first — I recommend short (<1 year), intermediate (2-5 years), and long-term (>5 year) goals. This allows you to start to plan for and meet your goals systematically, grading your performance against them along the way. This also guides the investment vehicles you will choose to achieve each goal. Remember we discussed in THIS POST that you can select bonds with different maturities, stocks with various growth rates, or combinations of both that correspond with your horizon (NOTE: younger people should typically have higher percentages of stocks in their portfolios).
Another important measurable is your personal risk tolerance. Consider today you have a retirement account with $500k in it. What is your reaction if your account retreats by 10%? 20%? 30%? 50%? If you are honest with yourself, this test will allow you to limit your risk in accordance with your own personality rather than outside advice (which is usually based on their own personalities). If your $50k shrinks to $25k and you believe you have the heart to stick it out — or perhaps buy even more of a good asset — you should pursue an aggressive portfolio. If you know that you would be concerned if your $50k drops to $45k, you will want to make sure you are including bonds and perhaps hedges such as gold to protect yourself from downside risk. Risk tolerance trumps any advice that I give about time horizons. Only take on as much risk as you desire.
What is your reaction if your account retreats by 10%? 20%? 30%? 50%?
Remember that time horizon(s) and risk tolerance must be considered when crafting your investing thesis. If you decide to invest in industries or companies without considering these factors, you are imputing unecessary risk into your portfolio and perhaps even dooming your results at the outset. Prior planning is essential because luck favors the prepared.
Anything I should add? Drop me a line below.