We all know we are supposed to invest money to build our financial future. You can invest in many different types of accounts, types of investments, and then a nearly endless array of individual investment options. Each account type, each asset class, and each individual investment serve some sort of purpose in the investment world. While not everyone may understand all of the details around stocks, bonds, 401k, IRA, Roth, etc… we are familiar enough with them to understand we should be doing these things to some degree.
How do you know which ones to pick? How do professionals know what to suggest to you?. In order to work our way through the decision tree to understand what investments make sense for you, there are three things that are fundamentally important to know before you begin investing.
1. What is your investment objective?
Before investing any money, this is the first question you need to ask yourself. Very simply, what am I investing this money for? This seems like such a simple concept but is overlooked by so many people. Too many people want to get straight into the conversation about what stocks they should buy. Should I buy an S&P 500 index fund or that new ESG fund, is Apple still a good investment or should I go for Tesla in my Robinhood account? While these may be valid questions eventually, they should come much later in the process when trying to determine what to do with your money.
Think about all of the different reasons we might save or invest money. Retirement, college savings, wedding, vacation, charitable giving, down payment for a house, rainy day fund, a new car, leaving money for your kids. You get it, the list goes on and on.
Let’s go through some examples. If I understand that a client wants to save money for retirement that immediately focuses me on a certain set of retirement related accounts. Based on a client’s desired retirement age I can determine that the client is knowingly setting aside this money for a longer period of time. Now depending on other pieces of information such as employment situation, benefits, and income I can narrow down further to what I think the best account type might be (401k, IRA, Roth, SEP, Solo 401k, etc..).
What if you use my Robinhood or similar brokerage account for this? A Robinhood type of account might come into play here too but probably only after I’ve exhausted what I can do with tax advantaged retirement accounts. The government has given us tax benefits for money set aside for retirement so why wouldn’t we put money for that purpose in those accounts? If I can avoid paying tax on the money now (like an IRA or 401k) that makes more sense than putting it into a brokerage account where I contribute after
tax money and then get taxed again when I sell the investment.
What if you use your savings account? With a savings account, we avoid the taxes on the back end but you just don’t get the growth that most of us need for retirement. Most standard savings accounts are paying a fraction of 1% right now. That money is losing ground right now to inflation. That certainly doesn’t work when we need that money to grow for our long term future.
Understanding that we want that money for retirement drives a decision process that provides a clear benefit for us when compared to putting that same money into a savings account or brokerage account. That example seems pretty straightforward, right?
How about a rainy day fund? Does that same retirement account work here? Most likely not. The point of the rainy day or emergency fund is that we need to be able to access the funds quickly to deal with whatever is going on. Getting money out of an IRA may take time and you will have to pay taxes on the withdrawal and possibly a penalty as well. This might be a better spot for a traditional savings account.
How about If the client wants to save for their child’s wedding? Does the same account we used for retirement work here? Maybe, but maybe not. I’ll address the rest of this scenario in a later section.
Understanding your investment objective is the first step to knowing what investment you should make. Without knowing this, you may not have access to the investment options you need for adequate growth, it might be tied up in an account you can’t access or you may have to pay a penalty to get the money.
2. What is your investment timeline?
Put another way, when do you need the money? Once we have determined why we are saving or investing money we need to know when we need it. Think about the items listed above for why we save money. For some of these, we may need the money in a few months and others may be 40 years. This can drive several decisions for us such as account type and maybe the asset class we invest in.
Let’s go back to our retirement scenario. Hopefully, you have already been investing in tax advantaged retirement accounts but what about the next step in the decision tree? Let’s say you are 58 years old and want to retire at age 60. That leaves you with a two year investment timeline. Do you want the money that you need in two years invested in something volatile like Bitcoin or a single company stock? Riskier assets tend to have higher returns in the long term but can be very up and down in the short term. You need to make sure that money will be there because you are depending on it. Two years may not be enough time for your investment to recover if something goes sideways.
Now that doesn’t mean you can’t be invested in things like Bitcoin or own a volatile stock like Tesla for your retirement. They just need to be in the part of the portfolio dedicated to your longer term needs. You may benefit from the long term growth in money that can sit there for 10 years and ride out the short term ups and downs but overall have a higher rate of return over that timeframe.
So what about our rainy day fund? The point of the rainy day fund is we don’t know when that rainy day will be. You may go to start your car tomorrow and find you need a major repair. Next week your furnace may go out. Your employer could do a round of layoffs this spring. Or maybe none of this happens for several years. We just don’t know. Because of that, we keep this money very safe, usually in cash or some sort of low earning account. Again, we may need access to the funds in the next day or two.
Ok, then, what about your child’s wedding? We punted on that one in the first section. The answer may vary depending upon a number of factors. What age will you be when your child will likely marry? If you had your child under the age of 30 there is a decent chance you will still be working if/when they decide to take this step. As a result, planning on using your 401k money for this might not be the best idea. Again, risk of taxes and penalties. Having money in a Roth or a brokerage account might make more sense for this purpose because we make withdrawals without penalties to an extent. Now for the second part of the equation, we now know the account to use, but what type of asset should I invest in. If your child is 8 and you are really into planning ahead then you can be riskier with this as hopefully, you won’t need it for quite some time. On the other hand, if your child is 25 and is in a serious relationship you may need that money much sooner and may want to make sure it is in something more stable.
Another way to think about investing timeline is how much risk can you afford to take? This is different than our next section, risk tolerance. You may be very risk tolerant and not worry when markets become volatile, but the bottom line is, when you need the money, it needs to be there and you need to invest accordingly.
3. Risk Tolerance
This is simply the amount of risk you are comfortable taking. We use this in conjunction with the previous section’s topic, investment timeline, to determine the proper amount of risk in your savings/investments.
To illustrate risk tolerance, let’s go back to our retirement scenario. We have already established that we have a 58 year old who is looking to retire in two years. We now know that the portion of her investments she will need in the next few years should be less risky because they are depending on that money being there for their living expenses. Does that mean we go aggressive with the rest of the retirement savings?
Not so fast. Our near retiree will have gone through the dot com crash in 2000, the aftermath of 9/11, and the financial crisis of the late 2000’s. Living through these experiences impacted us all in different ways. Some gained confidence in the economy and the financial market’s ability to rebound and come back to new all time highs. Others were scared off and live with the worry that they might see their retirement savings go up in smoke or don’t trust the market. To be clear, there is no correct way to feel about this. There is no right or wrong approach to take. This is a completely individual feeling and needs to be considered when investing. Just because I have confidence that the market will rebound doesn’t mean you are required to feel the same and as a result, be forced to have more risk in your investments than you are comfortable with.
Look, it’s one thing to say you don’t care when there is a one day 300 point move in the Dow. It’s another to stick to your guns when the market has 10 days of 1000 point plus swings like we did in early 2020 as a result of Covid or when the market was going down 40% in 2007-2008. These things can and do happen in the market. There is a real risk with investing and we need to be aware of it and you need to be honest about how much you are willing to take on.
Going back to our near retiree, if they came out of those experiences feeling comfortable about market risk, we may be more inclined to put more risk in that portion of investments intended for longer term use. As a result, maybe they have some Tesla or Bitcoin alongside that ESG and S&P 500 fund as part of a diversified portfolio. We still would keep that portion we need in a few years less risky even if they are comfortable with the risk because, again, they need that money to be there. If, on the other hand, those past experiences gave them doubts about the safety of their investments, we would be inclined to make that longer term portion less risky. As a result, maybe we forgo Bitcoin and individual stocks and have more broad index funds, bonds or low volatility funds.
If you find yourself with $10,000 and are looking to invest, don’t just buy some stock in a brokerage account because you heard about it on tv or through a friend or feel like it has to go in a retirement account. Invest with a purpose. Think through what you want to do with that money, when you will need it and how much risk you are comfortable with. By addressing these three fundamental questions you can get a much better understanding of what an appropriate investment for you is. This may not get you all the way to picking a specific stock, mutual fund or ETF but should get you to the right accounts, asset classes and investment mix. To be honest, that’s probably more important than picking Apple versus Tesla.
This is not intended to be taken as specific advice for an individual or a recommendation of any specific individual investment. Any investments mentioned in this post are for illustrative purposes only and are not intended to show approval or disapproval of those investments. Please contact a financial professional prior to investing to understand the risks involved and identify items that are appropriate for you.