Now you know a little bit about investing, let’s get started.
My friend Robert is a chef. He’s very good at it, having worked in and run restaurants in Scotland, England and Australia. He loves it. His latest venture has just been refurbished, at great expense, and can now seat over 150 guests. The restaurant’s evening meal time runs from around 6:00 to 10:00. You could say that Robert works four hours a day. I think he’d get a laugh out of that because he often starts work at midday. He thinks a lot about the menu, sources the right ingredients, supervises his staff and watches the dining room being set up for the evening meal. His biggest task is to oversee the mise en place in the kitchen. This is a cheffy expression meaning “preparation”. Before the evening cooking can begin there are hours of preparation to be done: ingredients chopped, sauce bases created, pots and pans prepared, ovens heated. There are myriad small and large tasks that need to be done before the real business of a kitchen — the cooking — begins.
So it is with investing. Before you rush into pressing the Buy button on your share trading app or transfer money to a fund manager make sure you have answers to the questions below.
A visitor to a Scottish village stops a local and asks, “Can you tell me how to get to Aberdeen?”
The local answers, “Och. If I were going to Aberdeen, I wouldnae start from here.”
Just like our visitor to Scotland, no matter where you’re headed, you have to start from where you are. You can’t go back in time (which would be nice, for many reasons) and you can’t magically increase your wealth. Therefore you must keep your objectives realistic and ensure that your circumstances allow you to achieve your desired result.
What’s your goal?
You wouldn’t get in the car and start driving if you didn’t know where you were headed. Your investment should be focussed on a particular goal; this will help to answer the remaining questions and will give you, or your financial adviser, a clear understanding of what you hope to achieve.
Whether it’s saving to buy a house, to create a school fees fund or to save for retirement, clearly identifying your investment goal provides clarity for everyone involved and also allows you to measure your progress.
Take some time to define your goal really well. “I want to be comfortable in retirement” isn’t a goal, it’s an aspiration. What does “comfortable” mean? A better-defined goal would be “I have 25 years until I retire. I want to be able to spend $50,000 per year over 20 years of retirement and draw down an average of 4% of my capital annually over rolling three-year periods”. This goal is clear, measurable and, subject to certain assumptions about market returns, allows you and your financial adviser to choose the right mix of investments that is most likely to achieve your objective. Better still, it allows you to monitor your investments and to make the right adjustments along the way.
What’s your time period?
Have you read the story of the entrepreneur who bought a company on Monday, tripled his money by Thursday and on Friday flew his helicopter to the French Riviera for the weekend? Sorry to burst your bubble but that’s not going to happen to you (or me).
Your investment time period depends on when you want to use your money. Remember from an earlier post that the longer your investment can compound the larger the potential return. Some goals, like saving for retirement, are long-term. Others, such as saving for a house deposit, even though they will take a number of years are much shorter-term. In general the longer your time period the greater proportion of risky assets you can invest in, since any short-term losses have a longer time to be recuperated. In any case the mix of assets that you invest in will be determined by your time period.
What’s your budget?
Carefully analysing your income and expenses will allow you to be more exact in determining how much you can save each month. By being diligent and honest with yourself about your income and expenses you will be able to create a budget and work towards your investment objective. You will probably have to trim your more frivolous spending and be strict with yourself if you want to get the best results.
What’s your required return?
This is where reality bites you, sometimes quite hard. Having chosen your goal, decided your time horizon and fixed the amount you can save each month some reasonably straightforward maths allows us to calculate the required return you’ll need to make your plans a reality. You’ll quickly find out how realistic your goal is when you calculate the return you’ll need every year to achieve it. It could be that you’ll need an unachievable return which will force you to lower your final amount, lengthen your time period or increase your rate of saving. Or perhaps you’ll have to revisit your objective completely.
What are your risk appetite and risk tolerance?
One final point concerns the concepts of risk appetite and risk tolerance. Risk appetite describes your personal preference for taking on investment risk and is therefore a subjective measure. You might be carefree and happy to “give it a lash” or you may have a much more conservative outlook and lean towards safety and security. Risk tolerance, on the other hand, is your actual ability to take investment risks in the context of your goals and life-stage; it’s much more objective. For some investors these two concepts can be at odds with each other.
Take, for example, a 63 year old in full-time employment nearing retirement. They may feel that, with more in their investment balance than they were planning to have when they retired, they can take a high-stakes gamble with some of their money. Their risk appetite is high. However at their stage of life a more conservative and risk-averse approach may be more appropriate since they don’t have a long time in the work force remaining in which they could earn a salary to recoup any losses from a high-risk strategy which goes badly. Their risk tolerance is potentially quite low.
Alternatively, a young person starting work straight out of higher education has a full working life ahead of them and has a high risk tolerance, even if they have a low appetite for investment risk. The time to recover any losses from a higher-risk strategy is greater than forty years and, in the early stages of investment, the cash magnitude of any losses will be small.
No matter what the life stage of an investor it’s often the realm of a financial adviser to provide guidance and advice in cases where an investor’s risk tolerance and risk appetite do not work together to help achieve the investor’s goals.
You should have well-thought answers to the questions listed above to give yourself and your financial adviser a solid framework for devising your investment portfolio. The answers to these questions will guide you towards creating the right plan for your needs. It’s only with a fully-developed plan that you can start to allocate your money to the various investments you have chosen. This plan will include the individual assets to buy that will maximise your chances of investment success, and perhaps a roadmap to change the risk of your portfolio as you get nearer to your goal.
Stick to the plan
You’ve answered these questions and you may have spoken to an adviser and are ready to get started. It’s important to note that once you have an investment plan it’s vital that you stay with it. Investment markets can, and do, move around a lot. This can weaken your resolve and make you want to change your plans. This won’t always be helpful; it’s better to stay on track and keep your eyes on your investment goal.
So, how do you start investing? With solid preparation. Just as our chef Robert wouldn’t start service without completing the mise en place, the start of a successful investment begins with planning for an achievable goal.
The Money Question 