When people learn that I’m an investment adviser, the first thing they mention to me is that they have some money to invest. Then, without fail, they ask me, “What can you do with it?” I respond by asking them two questions: “What’s the money for?,” and “When do you need it?”
Investing with a Purpose
When it comes to investing, all monies must have a home or a purpose. Is the money you’re investing earmarked for retirement, your child’s college education, a house purchase, or some other goal? The goals that you are investing for and the amount of time you have to invest before needing the money is critical to determining how best to invest it. If you do not answer those two primary questions, you risk investing blindly and without purpose.
Knowing the purpose of the investment will determine what the most appropriate type of account is for that money. For example, if you know that you have a goal to save for your child’s college education, a 529 plan may be the most appropriate type of account. This is because you could take advantage of the tax-deferral as opposed to investing in a custodial account for the child such as a Uniform Transfer to Minor Act or UTMA, where it is taxable and the child can use it for any purpose (not necessarily their college education) when they reach majority age.
If the money is for retirement, funding an IRA (Roth or Traditional depending on your income) may be the best type of account. On the other hand, if the money is for a down payment on a house or car, then a regular brokerage (non-qualified) account would be the right type of account. Knowing the goal you are investing for is critical to ensure that you not only maximize any tax advantage accounts available to you, but also to make sure that you have access to the funds and will not be penalized when it is time to use the money for that goal.
Know Your Timeframe
Knowing the timeframe of the goal is another important factor to determine the most appropriate allocation of funds. Without assigning a timeframe for the goal, you risk allocating the money into investments that are volatile and may fluctuate in value more than the time you have for it to recover.
For example, if you invest in stocks and need the money in less than a year, the likelihood of the value being greater than your principal amount invested is 50/50 at best. In other words, no one can consistently predict whether the market will be up or down on any given year.
Here is a good allocation rule to follow:
– Allocate your money in cash (savings, money market) if you have a goal with a timeframe of 24 months or less
– Allocate your money in bonds (investment grade) if your goal is between 2-5 years
– Allocate using equities (stocks) for goals with a timeframe of 5 years or more
By following this basic asset allocation, you will ensure that you do not assume more volatility in your investment than needed to achieve your goals.
This type of investing is called goal-based investing. It matches the timeframe of the goal you are investing for to the appropriate asset class. In almost 20 years of managing money for individuals, families and institutions, this method of investing has ensured that my clients have achieved their goals through both bull and bear markets.
Case in Point
Back in 2005, I began working with a young couple in their thirties with a two year old son. The husband had recently inherited some money from his mother’s estate. They knew it was too much money to hold in cash, especially since they had things they wanted to accomplish. So, we began to discuss their goals.
By talking about their financial goals, I found out that they planned on adopting their second child in the next two years and had already begun the adoption process. They also told me that they would need to replace one of their cars in the next three years. In addition, they wanted to save for their son’s college education in 16 years, and their own retirement in 25 years. Last, they wanted to keep some cash reserves for emergencies.
By identifying their goals and the timeframes for each goal, it was easier to construct the proper allocation for the inheritance. For purposes of this story, I won’t go into the details of how the money was divided up into each goal.
The true test of this goal-based investing method came three years later. It was time for my client to go to China to pick up their adopted daughter. It so happened that the credit crisis hit and the market fell 37% in 2008.
Since we allocated their investments based on when they needed the money (timeframe for their goals), the money earmarked for the adoption was never invested in the stock market and was allocated in cash. As a result, they were able to achieve their goal of adopting their second child even at the depths of the Great Recession.
Their college and retirement investments were allocated in stocks, so their values were down during that time. But they understood that they didn’t need that money anytime soon, so they remained invested in the stock market through the market’s downturn. In fact, we never sold a single share of their equity positions. Today, their investments have not only recovered to their pre-2008 values, but have well surpassed them as the market continued its climb into record territory.
Knowing when you need the money and what it is for is critical to proper investing. It could easily have been the case that another advisor would have answered the proverbial question of “what can you do with it?” by focusing on investing the money solely for the purpose of generating a return. In that case, the results would have been disastrous, and the client would not have been able to achieve their short-term goals.
Remember, investments are merely a vehicle to achieve your goals. At the end of the day, it’s all about your goals.