Saturday, February 28th, 2015

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How to Set Goals and Stay on Course

If you want your financial story to be a good one, learn from the craft of the storyteller: don’t start writing until you’ve figured out the whole plot.

There are three aspects of financial "plotting" that you need to focus on:

  1. Your goals
  2. How you divide up your investments to pursue those goals
  3. The role of diversification in pursuing those goals.

Money has been called the universal solvent, because it seems to solve all problems. Hmmm… not quite.

It is true that goals, especially big, life-defining ones, depend on having enough of it at the right time. Money can’t buy you love, as The Beatles pointed out, but it can buy you opportunity. So ask yourself what you hope to achieve in the next five, 10, 20, 40 years. Start an emergency fund? Get better disability or life insurance? Go back to school? Put a down payment on a new house? Change careers? Get married? Send your kid to college? Travel to Africa? Retire early? All of the above? Just how expensive do you plan to be?

What Do You Have?

And now compare the future dream with the current reality. First, you need to get a handle on what you’ve already got. Estimate both your net worth and your net income/expenses. Your net worth, what accountants call a balance sheet, compares your assets (what you own) with your liabilities (what you owe). It’s a snapshot of your financial condition at a specific time. Your net income/expenses helps you see your monthly disposable income – the income you have left over after paying all necessary expenses. And that tells you how much you can afford to contribute to your financial goals each month.

Allocate Your Investments

Now for the core of a good financial strategy: allocating your investments. Most people need investments that look like a multi-layered wedding cake. By starting at the bottom and working upward, you can build a solid financial structure, and pursue long-term goals while minimizing risk. With each complete level, you add flexibility and reduce the risk of relying on "basic" assets in a crunch.

In order to provide for our basic needs, like food and shelter, we want highly "liquid" (i.e. accessible) cash assets. We should probably also put life insurance and disability insurance on the "first tier" because, especially for anyone with dependants, protection in case of death or disability is also a crucial part of any secure financial foundation.

Income Generation and Wealth Building

The next two levels are income generation and wealth building. For some people, such as retirees, bonds are an important type of investment because they generate predictable income, and are at a higher rate than cash assets like savings accounts or CDs. But for long-term investors, and especially younger investors, generating current income isn’t as important. Income ceases to be an investment goal, and may even be a mistake. It can turn your gains into taxable income and instead, wealth building is what you’re concerned with. So it’s common, and it makes sense, to have a "thin" income generation tier and a "thick" wealth-building tier early in life, with the balance gradually switching as you reach retirement.


Alright, already, time to stick the cake metaphor down the garbage disposal. In a cake, every slice on a given tier should look and taste the same. Not in your portfolio. Suppose Robert’s stock portfolio is all "aggressive growth stocks," and Robyn’s is all "value stocks." Robert and Robyn might see roughly equal portfolio volatility over time. But they won’t be a bag of nerves (or pleased with themselves) on the same days, because historically growth stocks have tended to rise as value stocks fall, and vice versa. It follows that, if they both mixed the two types of stock in their portfolios together, they would probably lower overall volatility.

It’s called diversification, and it means, quite simply, that you shouldn’t put all your eggs in one basket. Of course, people with just half a dozen eggs look pretty silly carrying one basket for each egg. So to begin with, you may just own two or three different stocks, but as your personal balance sheet grows it will be prudent to consider diversifying by adding additional stocks to your portfolio.

The idea behind portfolio diversification is really very simple: to even out the risks of investing. Different types of companies (and different sectors of the economy) do good and bad at different times. Therefore, "narrow" stock portfolios tend to show returns that are either amazingly good or horribly bad, and "broad" or diversified ones tend to gain and lose much more moderately. Plenty of people with narrow "technology" portfolios saw their net worth double in 1999 and then halve (or worse) in 2000. People with a "broad" mix of stocks may have cursed their boring choices in 1999, but they thanked their sensible stars in 2000.

Find Rebalance

A final word. No, the final word isn’t "zymurgy," as Webster’s will lead you to believe; it’s "rebalancing." If one sub-set of your assets does much better than another, that will skew the overall allocation of your assets based on current value. Perhaps ballooning tech stocks and stagnant industrial or financial stocks suddenly meant that you had 30 percent of your assets in software at the end of 1999, instead of the 10 percent you intended. Time to consider rebalancing back to your intended asset allocation model.

You should review your portfolio once a year. However, it may be best not to react by selling one thing just to buy another. If rebalancing is an issue, your first tactic should be to review your long-term goals and consider shifting your overall pattern of investing until the imbalance is managed.

The page turns. The plot unfolds. Just remember: it’s your story, so you decide what happens next.

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