At each stage in your life it is important to consider wealth creation and wealth preservation. Building wealth for you and your family should be a priority at all times in your life. There are numerous ways to provide for the different stages in your life.
Set a goal to motivate yourself to invest rather than spend. It could be to retire comfortably, to buy a car or house, finance a wedding or a child’s education, or simply to have a holiday or a hot new iPhone. Aim to invest around 15-20% of your income for retirement (depending on your age), and 10% for other goals. Draw up a budget for this and make sure you stick to it. Financial planning is the process which tailors a personal financial plan particular to your unique circumstances and focuses on what you need rather than what you want. You can then invest accordingly.
During times of market uncertainty a solid personal financial plan stands you in good stead. Many investors make the cardinal error of panic selling when emotions of fear and greed take over as we are barraged incessantly by diverging investment information that robs us of peace of mind and sleep. Even the most astute investors like Warren Buffet warn of the dangers of emotions in the investment process. By taking time to understand investment principles and constructing a sound financial planning strategy, many of these pitfalls can be avoided.
When developing a personal financial plan it is important to first define your own objectives, such as when you want to retire and how much monthly income, in today’s Rands, you would like to have during retirement. Gather as much financial information as you can and value your current investments. It is then possible to calculate how much additional capital will be required at retirement. Various factors must be assessed at this stage, including how long you intend to invest and different tax implications. Adding complexity will be the analysis of how high the investment return needs to be to provide that “pot of gold”. At this stage your required investment strategy will become clearer.
Investment markets are quite complicated, even for those with a higher than average IQ. Simply put, there are really only four things in which you can invest your money: shares, bonds, property and cash. Sure, you can invest in paintings or sculptures but these are speculative assets. The decision to invest in shares, bonds, property or cash is known as the asset allocation decision. Most investors close to retiring need to grow their capital at a rate above inflation net of tax and should ideally be spreading their investments between the various asset classes. Equities do provide inflation-beating returns, but they also carry the greatest capital risk. Cash and bonds are considered lower risk investments, but are at the cost of lower returns. Retirees would typically wish to have most of their funds invested conservatively in defensive assets with most in cash and bonds. However, few can afford this luxury. They usually need some exposure to the inflation-beating returns equities provide. They also need to consider that interest earned from conservative investments is taxable. This can further erode the capital. Taking into account the risk and returns particular to each asset class, you must allocate funds between the asset classes according to your needs and cash flow. The construction of your investment portfolio is something which should be done with an investment expert as the decision will certainly have far-reaching consequences.
Investors frequently make investment decisions according to what they feel comfortable investing in rather than what they need as an investment return. If you are by nature a risk-averse person you will probably choose a more conservative portfolio, while an aggressive investor may choose a more aggressive portfolio only later to possibly fall into the classic trap of panic and selling.
When it comes to financial security, it is important to have a plan. As the old saying goes, failing to plan is like planning to fail. You should, in consultation with a professional financial planner, devise a written financial plan that takes the following factors into account:
YOUR GOALS AND OBJECTIVES
Make sure your financial security goals are appropriate and achievable. For example, planning for your child’s tertiary education or planning to retire at 60 are goals and objectives whereas planning to beat the market is not an appropriate goal or objective.
You should, with the help of your financial planner, be able to define the risks to your portfolio. Risk tolerance is very personal and differs according to each individual. For a 30-year-old saving for retirement, short-term volatility should not be too important, whereas volatility will be crucially important to a person only months away from retirement.
Inflation must be taken into account as a significant risk for every investor because of its ability to erode the purchasing power of any capital.
This is the split of a portfolio among the various asset classes (bonds, property, cash and equities). Your asset allocation should help achieve your financial security goals while minimising risk.
This ensures that all your eggs are not in one basket. Asset allocation is the first level of diversification. Within each asset allocation you can get further levels of diversification. For example, within equities you may diversify your portfolio by choosing large cap, mid cap or small cap stocks or diversify by choosing equity managers with different investment philosophies.
APPROPRIATE TIME HORIZON
Your written plan’s guidelines will help you adhere to a sound long-term policy even when market conditions are turbulent. Having a well researched investment plan and sticking to it is not as much fun as trying to time the markets, but it will more likely to contribute to long term financial security. Most investors are too focused on the short-term results. For example,if you are saving for your retirement in 30 years, what the stock market does this year or next year shouldn’t be your biggest concern. If you are saving for a child’s tertiary education and he or she is in primary school, your time horizon is shorter and this should be reflected in your asset allocation.
Rebalancing is the process of returning your portfolio to its target asset allocation as outlined in your financial plan. Rebalancing may be difficult when it forces you to sell an asset class that is possibly performing well and buy more of your poor performing asset classes. A portfolio allowed to track the market returns ensures that certain asset classes will be overweight at market peaks and under weight at market lows. This is the same as buying high and selling low – a formula for poor performance and ultimately, no friend of financial security.
Investors select asset classes, strategies, managers and funds based on “past performance”. Chasing past performance has probably led to more bad investment decisions than any other single factor. A comprehensive study done in the US indicated that the dollar-weighted returns were consistently lower than the time-weighted returns. Over the course of an 80-year period in the US, investors received 1,3% less a year because they went in and out of funds at the wrong time. At first impression this does not seem like much, but the compounded effect over a period of 80 years is mind-boggling. If a particular asset class, strategy or fund has done well for five years, we know only one thing with certainty — we should have invested five years ago. We should not necessarily be pouring money into the fund now.
Financial reporters purporting to know which is the next top performing share or fund often destroy more wealth than they create. In today’s world of instant communication and information at our fingertips, once the news of a hot stock has hit the press it has already been factored into the share price. To remain objective and focused on your goal of future financial security, engage the services of an independent fee based Financial Planner professional to help you to develop your financial plan or review your existing financial plan.
Remember that your financial plan should be reviewed annually and sooner should there be any life changing event, for example, a change of career, birth, death or divorce.
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