When constructing a new house, you need to begin with a solid foundation. Otherwise, your home will always be a bit shaky and prone to collapse in a storm. That same principle applies when you start investing. Rather than taking a random approach — like buying a “hot” stock or keeping your money “safe” in a low-earning savings account — you need to start with a solid foundation. In the investing world, that means developing an investment plan and perhaps an investment policy — two basic tools that can help you build a solid financial “home.”
First, let’s look at an investment plan, which is often prepared with the help of a financial advisor. The plan typically has three basic elements: your goals, your risk tolerance and your desired return.
Usually, your financial goals will be closely aligned with your personal objectives in life. Perhaps you want to have $2 million in assets to support a comfortable retirement. Or you might be aiming to save $150,000 for a bigger house for a growing family or $100,000 to put your son or daughter through college. If you already have accumulated a large nest egg, you might focus on how best to pass your investments on to your children or grandchildren.
Having a clear goal in life — and in your investment plan — may be one of the essentials in building wealth. Rather than spending every dollar from your paycheck, you can start putting away some of that incoming money to prepare for the future.
Next, you should consider both your tolerance for risk and your desired return on your investments. Some people are willing to make higher-risk investments, while others prefer to sleep soundly at night knowing their investments are comparatively more secure. After all, assets like stocks and commodities are usually more volatile than bonds or other fixed income instruments, and rise or fall more steeply from day to day.
However, many of the more volatile assets can also generate higher returns over the long term. That’s an important consideration because inflation can reduce the purchasing power of the dollars you stash away in money market accounts or other low-earning securities.
That’s why a solid investment plan usually incorporates a diversified mix of assets, including stocks, bonds, cash-like securities, and possibly real estate, commodities, hedge funds and managed futures. Building a diverse portfolio reduces the risks associated with putting all your eggs in one basket with the potential to generate positive returns over the years and keep you moving steadily toward your goals.
Now, let’s look at your investment policy. This is a written statement designed to guide both you and your financial advisor when making financial decisions. It can help you balance investment issues related to risk and reward, perhaps ruling out certain assets as “too risky.”
At the same time, developing an investment policy helps you reality-test your financial goals and current savings and investment plans. For example, you might be overly optimistic and expect a 12 percent annual return on your portfolio. Or you might be overly pessimistic, not realizing how your investments will grow with even a 5 percent annual return.
An investment policy can also clarify the roles of your financial advisors, as well as your own decisions. In that regard, it can help you avoid making investment mistakes based on emotions like fear or greed. In other words, it helps you maintain a disciplined steady course toward your goals, regardless of market ups and downs.
Finally, the investment plan and policy can provide tangible evidence of your financial progress. Your advisor can send you quarterly and annual statements (as well as discuss in person) that clearly show whether your portfolio has grown or declined, and where the changes occurred. This is information you need to know in order to make good decisions about your financial future.
So, consider your financial plan and policy as a road map. You may not yet be close to your goals, but at least you know you’re on the right path!
Andrew Menachem, CIMA, CWS is a wealth advisor at the Menachem Group at Morgan Stanley Smith Barney in Miami and Aventura and teaches at the University of Miami.