Objectives-based Investing for Beginners

Florida Prepaid Open Enrollment
October 16, 2017
Calm seas representing conservative investing
Is it Okay to be a Conservative Investor?
October 18, 2018
Bull's eye target carved and painted onto tree. Meant to represent an objective or target.

The most important thing a potential investor must know is that it is never too early or too late to start planning your financial future. Regardless of your age, now is the perfect time to start investing for tomorrow, and this article will get you pointed in the right direction.

Though we won’t dive into the intricate details of all the account types and investment vehicles available, my goal is to give you enough guidance that the next steps can be taken on your own. By the time we’re done, you should be able to construct a basic savings strategy relevant to your objectives and then set up and fund your first account(s), all without feeling lost in the complex world of personal finance.

Qualities of Good Financial Objectives

“Those who fail to plan, plan to fail.” These may be the ultimate words of wisdom when it comes to mapping out our economic destiny.

Setting objectives is the first phase of any investment plan. However, these goals aren’t necessarily the fantasies occupying your mind during those late nights at the office. There are certain qualifiers which must be applied if you are serious about your goals. You can remember them by the acronym, “SMART.”

S = Specific

Saying, “I want to buy a boat someday” is not specific. How much will it cost? When do you want to buy it? How much will it cost to maintain it? These are the kinds of things you need to know for each objective to arrive at the figures you’ll need when determining how (or if) it can be achieved.

M = Measurable

This becomes critical when dealing with assets that are difficult to value over time. For example, if you are counting on Great Uncle Mortimer leaving you several expensive paintings in his will, it’s hard to know exactly how much they will be worth, or when you will enjoy the proceeds- if ever. It’s not a good idea to rely too heavily on anything with a value which cannot be reliably and/or accurately measured along the way.

A & R = Attainable & Realistic

Each goal you set must be something you realistically have the means of attaining. I encourage people to aim for whatever they want most out of life, but if those things involve lottery winnings or buried treasure I try to help them lower the crosshairs a bit.

For the most aspirational of objectives, it is best to set a series of smaller, easier to attain goals that contribute to the fulfilment of a grander plan. This keeps morale up while providing a means of progress measurement over time.

T = Time Bound

Objectives work best when there is a deadline. The period between the initiation of an investment plan and the objective deadline is known as the investment time horizon. The time horizon affects almost all other aspects of an investment plan.

The Investment Checklist

After applying the SMART filter, here is the information you should have on-hand:

1. A dollar figure associated with each of your objectives. If you are unsure of just how much you’ll need, a quick web search will provide plenty of calculators to help you hone in on whatever you’re after, be it retirement, a home purchase, college fund, etc.

2. The starting value of your investable assets. That’s how much you have available to invest right now.

3. A reasonable projection of how much you will be able to contribute periodically from today until the date you hope to hit your objective. This one will allow for some wiggle room since it’s hard to know precisely what your cash flow will look like over time. My recommendation is to see if you hit the mark using the most conservative estimates possible. If you can make it work, great! What you want to avoid is too much optimism coming back to haunt you late in the game.

4. The timeframes you’ll be working with. Even if you’re not sure exactly how much time is required, you’ll need to start with a fixed period for each objective. This number, like all the others, can be adjusted as you refine the inputs to something manageable for your circumstances.

The Required Rate of Return

Using a calculator like this one, you will input all the data you’ve accumulated thus far to arrive at that most critical of numbers: The required rate of return, or “RROR,” as we insiders call it. This is the average annual interest you need to earn on your invested dollars to meet your objective.

The significance of this figure is enormous. It will act as a guidepost, leading you to the types and mix of investment vehicles needed to get you to your destination, with risk-exposure being a primary consideration. Here’s what I mean:

Let’s say the calculator spits out a RROR of 2%. This would mean that you could reasonably expect to hit your objective using an extremely conservative blend of investments in your portfolio. If interest rates ever return to their historical norms, you might even be able to do it without taking any stock market risk at all.

If, on the other hand, your RROR comes in at 7% - all other factors being equal - you would need to start looking into riskier assets, since there’s simply no way to generate those kinds of returns at today’s fixed rates. Again, that may change, but it’s safer to avoid wishful assumptions whenever possible.

Once the RROR gets above 8%, it’s time to start rethinking the plan. Even though the average annual return of “the market” (a term usually describing the S&P 500 Index) has been around 10% for the last 50 years, most investors fall well-short of that due to the nearly unquenchable desire to start messing with allocations during intense periods of market volatility.

Fine Tuning

If you find your required rate of return to be excessively high (again, 8% is borderline; anything over 10% is approaching unrealistic), it’s time to start adjusting some of your initial assumptions.

As far as what you should tweak, it’s helpful to know that, aside from the rate of return, the factor with the greatest leverage is time- particularly if the target is retirement. Your start date should always be as soon as possible and the starting value is something you probably can’t change much. Unless you already have an excess of positive cash flow, your periodic contributions will be relatively static too, save for the occasional increases as your income grows.

Time, on the other hand, is something most people can control. If you need to work a few more years, that may be a lot less painful than running out of money due to a premature retirement. Plus, the longer you work, the smaller the nest egg will need to be since you’ll be drawing from it for fewer years.

If you still can’t get the numbers where you need them, it may be time to lower the expectations of just how sensationally fabulous that objective will be. Technically, a small mansion is still a mansion, right?

For folks lucky enough to start out with a low RORR figure (let’s call that 5% or less), you have a bonus option: If you are comfortable with the idea of taking on more risk, you can use this calculator to see the impact of bumping up that rate of return assumption. As you will see, just a little bit of extra interest each year has a huge impact on the future value of your investment, particularly over longer spans of time.

You can then take the new figures from this calculator back to the original one and experience the thrill of being able to reduce your target date or periodic contributions. Of course, such euphoria comes at the expense of greater market risk associated with the higher RROR- just keep that in mind.

As a word of warning: DO NOT push yourself beyond your level of comfort with market risk. Doing so often leads to poor, emotion-based decisions at the worst possible times. These kinds of mistakes can be the undoing of the most well-laid plans and should be avoided at all costs.

If you are uncertain of your “risk tolerance,” here is a quick tool that will offer some general guidance. It should be noted that attitudes towards risk often change over time, especially as you learn more about how investment vehicles and financial markets work. Again, the important thing is not getting too far ahead of yourself.

Selecting Investment Vehicles

So far, I’ve mentioned nothing about the actual investments you will employ to start your journey- and for good reason. Without understanding where you are trying to go and what types of investments you should be focusing on to get there, you are basically flying blind and hoping to land somewhere near your destination. Now that we’ve tightened things up a bit, you can move on to the next phase knowing the pre-flight checklist is complete and everything is in good order.

For those whose sense of what investing entails has been formed by what they’ve seen on TV, the tendency is to start out by acquiring stocks issued by a few companies they recognize and like. Once their account is set up, most waking hours are spent checking and rechecking the balance as they wait for their ship to come in.

If this describes your expectations, I’ll apologize in advance for shattering your dreams. The truth is, the odds of picking the next Amazon or Google in their pre-explosion years is about as good as getting hit by lightning.

And if you think today’s powerhouses (like Amazon or Google) will continue down their path of unstoppable appreciation … well, stop thinking that too.

In the 1960s and 1970s, there was a collection of stocks known as the “Nifty Fifty.” These were companies that seemed destined to stand the test of time, impervious to any kind of negative catalyst that would bring down any ordinary enterprise. Here are a few of those former stalwarts: Avon Products, Eastman Kodak, Sears, Polaroid, and Emery Air Freight—all companies that aren’t what they used to be, to say the least.

The lesson here is that innovation, competition, and corruption can change things in ways that none of us can imagine today. Remember Pets.com? How about Enron or Bear Stearns? Yeah, me neither.

The companies dominating their respective industries now may be completely irrelevant in just a few years, and, as the adage goes, “The bigger they are, the harder they tend to fall.” On the other hand, you never know which worthless startup will grow up to change the world.

Especially when starting out, a better strategy than picking individual companies to invest in is buying a basket of companies. This can hedge the risks of missing out on the next big thing and having all of your eggs in the basket of the next great disappointment. This is called diversification.

If diversification is the goal, what’s better than buying a basket of various companies’ stock, is buying baskets of various types of assets. Typically, stocks, bonds, and cash blended in proportion to create the desired risk/return profile provides the core types of assets that can get an investor started. However, purchasing a variety of investments of various asset types doesn’t exactly fit into the investment budget of someone just getting started.

One of the most efficient ways stretch an investment dollar in terms of diversification is through the purchase of mutual funds and exchange traded funds (“ETFs” in industry shorthand). For present purposes, we will limit this discussion to mutual funds since ETFs are a little more complicated and may be better suited for more experienced investors.

Mutual Funds

The basic building blocks of most mutual funds is a collection of stocks, bonds, and other securities representing different companies, sectors, and regions of the globe. These assets are managed by an individual or team of fund managers who build a portfolio aimed at a certain objective. You can usually get a sense of the objective by looking at the fund name. For example, a “Domestic Large Cap Value” fund would be focused on stocks of large, well-established, US-based corporations, while an “Emerging Markets” fund is going to look for stocks issued by companies in comparatively underdeveloped nations. A “Corporate Bond” fund invests in … you guessed it- corporate bonds!

The reason that mutual funds might be ideal for some beginner investors is that, instead of having to go out and purchase a large number of stocks or bonds of a variety of organizations – which could obviously get quite pricey – an investor can buy the less pricey shares of mutual funds which, in turn, own large baskets of investments. This provides proportional exposure to a mutual funds underlying investments without needing to possess the assets to purchase each of the investments individually. Diversification on a budget!

Now, there is a cost to this convenience. All investors, new and seasoned, need to keep an eye on the costs associated with any investment funds purchased. Although some fees are justified, excessive fees can crush investment performance over time. Often times, with a little due diligence, it is possible to find a fund with the same or similar underlying holdings offered to investors with fees that are less expensive.

There are all kinds of online tools to help you decipher what is going on inside each fund. But if all else fails, the buck ultimately stops at the “prospectus,” which every investment company must make available for every mutual fund they offer. This publication will give you more information than you would ever want to know, including holdings, past performance, expenses, manager tenure, etc.

How Risky is My Portfolio?

The critical thing every investor needs to understand about risk characteristics is that any assumptions one might make about tomorrow can only be based on past performance. And the tricky thing about looking backwards into the future is that we can’t be certain it will look anything like the past. But, since history is all we’ve got to work with, this is the basis of most tools investors use to peer into the unknown. With that disclaimer in mind, let’s continue …

The way most people think of risk is the likelihood of a loss of value. The more accurate way to think of risk, in my opinion, is the expected volatility of a position. Volatility encompasses both the up and downside potential, but, more specifically, the magnitude of those swings over a certain period of time.

You should expect that there will be fluctuations in the value of any market-based investment, but it’s the degree of those movements that will feel the most like risk as you white-knuckle your way through the market’s peaks and valleys. Unless you like drinking Pepto Bismol® by the gallon, it’s best to try to smooth out the ride as much as possible before you find yourself in a spot where emotions override rational decisions; especially at first.

The accompanying list provides a very broad overview of the risk profiles of the major categories of mutual funds you’ll find in the marketplace, ranked from the historically most volatile to the least. As you construct your portfolio, you can change the overall risk profile by adjusting the percentages of each type of fund in your allocation.

I want to emphasize that this list is a general guide. There may be some funds that don’t adhere to the position in my ranking, and there are several categories I did not list. It will be up to you do exercise your own due diligence when selecting the ideal picks for your portfolio.

If you really want to dive deep, I found this wonderful tool that allows you to enter the funds you are considering, along with their allocation percentages, so you can see things like maximum drawdown, correlation, total return, and all kinds of other pertinent factors. You can only add three funds without registering, but registration is free and, so far, I haven’t been spammed into oblivion.

Investment Account Types

The next thing to consider is the type of account you will utilize. This decision will be based on the tax-treatment you want applied to the assets and the options available for your circumstances.

For example, if you want tax-deferral (paying taxes later), you will be looking at things like the Traditional IRA, or perhaps a plan available through your employer. If you prefer a tax-free account, you’ll be interested in the Roth IRA option. If none of those fit your scenario, you may be setting up a “non-qualified” brokerage account, which has its own merits as well.

If you are unsure of which type of account is right for you, it’s best to seek council from a tax or investment professional. If you like podcasts, you can check out The IRA Brothers, which provides more details on the various account options available, along with other interesting financial tidbits.

Selecting an Investment Company

Okay, so we’ve figured out a basic objectives-based investment strategy, we’ve considered our risk tolerance and constructed a mutual fund blend to compliment it, and we’ve selected the most suitable type of investment account. The final step is selecting the company through which you will invest.

If you are only going to buy mutual funds (I’ll stick to this as my generic recommendation for anyone brand new to investing), you have two options for where the assets will be housed. You can either set up a brokerage account at one of the major industry players (Charles Schwab, TD Ameritrade, and Fidelity are a few examples), or you can invest directly with the mutual fund company of your choice. However, there are some pros and cons associated with each of these options.

If you set up a brokerage account, you will have access to virtually all of the thousands of mutual funds currently available in the marketplace. This can be beneficial if you want to mix and match funds offered by multiple companies. The downside is that brokerage accounts often charge commissions for each transaction which will range from $10-$25 per trade for most companies. If you aren’t starting out with a lot of money in your account, those costs could be high enough to completely wipe out your interest for the year.

It should be noted that most companies offer commission-free trades for certain funds, but those usually involve a holding period requirement that could be as long as six months. In other words, once you buy a position, you would need to stay in the position until the holding period expires to avoid both the buy and sell (or, as we call it, “round trip”) trading costs. If you are considering the brokerage route, just be sure you understand all the potential trading costs before pulling the trigger.

Alternately, you can avoid the trading costs altogether by opening your account directly with a mutual fund company. Though you may occasionally run into holding period requirements, they are sometimes much shorter than brokerage accounts. The drawback of a direct account is a significantly smaller selection of mutual funds, as you can only use those offered by the company. But don’t let that be a deterrent …

If you choose one of the larger companies, like the well-known Vanguard Funds, you will find a lineup of sufficient size that you’ll have no problem achieving adequate diversification amongst all the various fund categories and industry sectors. What’s more, Vanguard is notorious for their internal cost-efficiency. Low expenses mean you get to keep more of the raw performance generated by the fund’s assets each year (that’s a good thing).

There are several other great companies out there, and I have no personal stake in Vanguard Funds, but they should definitely be near the top of your list as you evaluate the options available.

Once you have settled upon your investment company/companies, accounts can usually be set up in a matter of minutes by visiting their website. Through that process, you will be asked to provide some general identification information to fulfill the US PATRIOT Act requirements, along with a few bits of personal financial data the custodian will use to assess the suitability of your investment. Additionally, you will have the option of linking the investment account to your local bank account. If you plan on making regular contributions, this feature will make life much easier. If you are the old-school type who likes writing paper checks and paying for the postage, you can still do that too.

Final Thoughts

Becoming a productive investor is a life-long process of learning and growing. There are plenty of resources available offering practical and technical knowhow, but there are some things you can only learn from experience- and I speak from experience.

You will make mistakes along the way- we all do. But that is all part of the learning process. To minimize the impact of any one mistake, use diversification to your advantage, and don’t risk your dollars on anything you don’t understand.

And, lastly, but perhaps most importantly: Nobody understands your hopes, dreams, fears, and monetary philosophies as well as you. Whether you intend to go this alone or eventually seek outside council, you have to know yourself well enough to express your objectives, risk tolerance, time horizon, and financial circumstances. Without this information, you’re shooting into the night. You might hit something, but, if you do, it might not be the target you were expecting.

Comments are closed.