Part of must-read guide: How to build an all-weather portfolio, step-by-step.
Step 6: Start with your goals to determine your appropriate level of investment risk.
Bonds are simple and essential in every portfolio. This part of the book is about you.
- What is your portfolio?
- How much of that should be in bonds?
- Which bonds should you choose?
A “portfolio” is an overly fancy word—but it will do. We need a way of thinking about what we have, and typically it is spread around in different forms (house, car, stocks), in a variety of accounts (banks, investments, retirement plans, Social Security expectations), and people (spouses, partners). The concept of a portfolio gives us a way to make good decisions and then get on with our lives.
Of all the decisions you’ll make, the allocation between stocks and bonds is the most important.
It is tempting to think that deciding which fund to own will determine your success, but it is very minor compared to your big decisions.
Start by asking yourself: What are you investing for?
Start with your goals.
- Plans only work if you make them
- A one-page plan will do
- Strive for a first draft now; improve it later
- Focus on high-priority goals
If you watch my video tutorials you know that I think everyone should have a 1-page plan that indicates some goals and how much money you will need for them. Write down your objectives and priorities. Don’t worry about correctness. Just strive for a first draft. You can improve it over time.
Key point: The best return on your time (ever) will be the time you spend setting goals.
Does it need to be written? I think so. But written on a napkin would be fine if you’ll promise to look at it at least once a year. Can you remember it instead? No. Write it down. One of your decisions needs to be your ratio of stocks/bonds investments and you’ll be very tempted to change them (in a bad way) every year if it is not in writing.
Start with a list and use placeholder estimates until you can improve them. For example:
Beginning in 20+ years
Hire in 1 year
Buy in 1 year
Child’s College Ed
Needed in 6-10 years
Create a realistic plan to finance at least all your high-priority goals.
Key point: Retirement is so costly it should be a primary focus for everybody.
There are significant advantages to begin saving for retirement as early as possible. It’s understandable that you may want to secure your short-term goals first, but you should consider resisting this temptation and maximize available tax-advantaged retirement savings options first. Find a balance of both. Only you can decide!
As a benefit to employees, many employers offer to match a portion of your retirement contributions. This match is like giving yourself a raise and may add a significant sum to your savings.
If you have high-interest loans and high-interest credit card balances, they must be a high priority. These are insidious and often lead to fees. Make it a priority to drive fees from your life! Wave warning flags at yourself if you own investments earning less than your auto loan or credit card interest—this is using debt to finance your investments and this magnifies your level of risk.
Saving to fund children’s college education may be an example of a high want. If your budget includes saving for this, you should consider the tax-advantaged vehicles that are available.
Short-term needs that are coming up in the next five years must be separated out for targeted short-term investments. There isn’t enough time to risk this in the stock market.
For example, Ruth is 35 years old and is on track for saving for the goals listed above. Money for her short-term goals is invested in short-term bonds. Her college savings is invested in a fund that is 60% stocks / 40% bonds which she will gradually change to a 100% bond allocation over the next six years. And her retirement is allocated 75% stock / 25% bonds which she plans to shift towards bonds at 1% per year.
Estimate what you will need for retirement (see sidebar). This is usually the biggest line item and necessary to establish a plan and view your investment portfolio in proper context. Really, anything less is just wishful thinking. Take a minute to think about this.
After you’ve taken a stab at your financial needs, you’ll want to compare this with your current situation, your net worth. The gap between where you are, what you will need, and your timeframe govern how much investment risk you need to take if your goals are to be met.
Usually people are not saving and investing enough to achieve their goals. Then it’s back to the drawing board: you will either need to work longer (retiring later is not always possible), save more, or lower your retirement goals. Once you have a first draft plan that supports your goals, you’re off and running! Review and revise it every year, and you’ll discover that it gradually improves with time.
And, only if the ability and willingness are truly there, you could consider a high exposure to stocks, according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.
Sometimes a young person is able to handle considerable risk, maybe towards 90% stocks, and rely on time to iron out volatile short-term returns. They are on a solid career path, save religiously from every paycheck, and have an established emergency fund in case of inevitable surprises.
Similarly, some seniors have adequate retirement income from Social Security or a pension and can continue to let stocks dominate their investments.
Saving for retirement is almost always your biggest goal. Next is a simple way to include a number in your goals. Yes, choose a specific number for a goal—you can always change it. But writing a number down is one step closer to creating a plan that works.
Is it difficult to estimate your retirement expenses? Then use a placeholder number—you can improve this estimate later. Are you seeing a pattern here? Any plan is better than no plan. And if you promise to look at it every year for at least 1 hour—it will become a pretty good plan!
Homeowners wonder about whether to treat the value of their home as an investment. Start with my short answer, then adjust it for your circumstances. It is both best and easiest to retire debt-free with your mortgage paid. If the interest on your debt is higher than the interest you are earning on your bonds, then the reason is obvious. Some people like to consider debt like negative bonds—then your investment risk is honestly revealed.
Many retire debt-free and don’t count their house value as an investment—but rather a provision for future rent payments as their needs change. But those that don’t have large savings locked up in their house as an investment do need to include a monthly housing cost when coming up with their living expenses.
Each of us, individually, must determine how much risk to take and how that translates to stocks and bonds.