Would you build a house without architectural plans? Would you take an extended road trip without GPS? Yet we often invest our money without a strategy (roadmap) in mind. When we generalize goals over longer time horizons, we have no idea if they are realistic or if we are on track to accomplish them in a time frame that we have in mind. Instead we live in fear that things won’t work out the way we hope they will. What’s wrong with that?
Just as there are several key components in building a home (design, structure, materials, time frame, costs, etc.), financial planning provides important information for your investment plan including quantifiable goals, time frames, your appetite for risk, savings, contributions, expenses, taxes and need for income. It is also measurable and can be adjusted as other key variables change (needs, income, interest rates). Financial plans help us understand where we are going and how to adjust for the unexpected changes in our lives.
Goal + Time Frame+ Risk Tolerance+ Tax considerations + Contributions + Income needed = Asset Allocation
Goals are the short- and long-term objectives we are striving to achieve. How much will we need and when will we need it? The financial planning process helps make them “real” by identifying specific elements including time frame, dollar amount, the time value of money, and sources of income to help fund them.
Goals can change over time. Regular, periodic check-ins help us measure how we are tracking and whether adjustments need to be made.
The better we plan for our goals, the greater the likelihood of accomplishing them.
Are your goals immediate (short-term) or decades in the future? Common goals include saving for college, retirement, down payment for a house, vacations, larger purchases or starting a business. Part of the financial planning discussion helps us prioritize goals. Time frames are important to investment plans. Funds for shorter term goals need to be invested in less risky assets. Should markets fall, there is less time to make up a decline in the market value of the assets earmarked for that particular goal. Investments for longer term goals can be invested in assets that potentially will return more over time and, should there be extensive market fluctuations, the funds have time to recover before they are needed. In addition, as time frames “get closer” adjustments can be made to the investment plan to make those now “shorter-term funds” less risky.
A very important component to investing is our “appetite” or ability to tolerate volatility in our investments. A financial advisor, once understanding your goals and time frame, will want to understand your ability to tolerate volatility. This is a very important element to designing an investment portfolio. If this isn’t taken into consideration and a portfolio is too ‘aggressive’, then the client could make emotional decisions during periods of high market volatility that erase all the good investment decisions that were made along the way. If a portfolio is too ‘conservative’, it might mean that money has been left on the table that may have provided for the goals the client is hoping to achieve.
Simply put, an asset allocation is the mix of different asset classes (stocks, bonds, and cash) in an investment portfolio. Asset allocation is the underlying strategy for how your funds are invested. Asset allocation is responsible for over 90% of a portfolio’s return over time* and can be adjusted. It provides the basis for measuring the investment results of a portfolio. Before making recommendations, an investment advisor worth their salt, wants to know your goals, time frames, risk tolerance, tax considerations, need for income, and ability to make contributions before suggesting an appropriate asset allocation. If these things are not thoroughly discussed, you should run in the opposite direction!
EXPECT THE UNEXPECTED
In summary, a financial plan is a living, breathing map for the financial foundation of life. It supports the journey, lifestyle, and endeavors that we strive to accomplish throughout our lives. It informs the investment plan so that we have confidence that our planning and investing are working together for the best possible outcome.
Jenifer Aronson is the Founder of Mosaic Fi.