Before you entertain the idea of investing any money, you need to make sure the rest of your financial life is in order. Here’s how to do that.

Don’t even think about investing any money in the stock market or anywhere else until you do this.

Invest in yourself first – your “human capital”. If you need to improve your job skills by taking a course, set aside money to allow for that. You have complete control over investing in yourself, and you will never have that control over investing anywhere else. You can also make extra money apart from a regular job by developing a second or related set of skills.

Participate in your company’s 401(k) plan if you have that option Should You Participate in a 401(k) Plan?

Establish an emergency fund for yourself. Think about what your biggest exposure is and set aside money to cover it. For example – an unanticipated car repair bill or an unanticipated vet bill. Don’t be like the large minority of Americans who cannot meet an unexpected $400 expense without borrowing it from friends or charging it to a credit card knowing they cannot pay the bill in the next billing cycle.

Understand the difference between good debt and bad debt. Good debt is money owed on an asset that is likely to appreciate such as a house bought at a fair price. Bad debt is money owed on credit cards or money owed on assets that depreciate such as a car.

Pay off all credit card debt but do not be in a rush to pay off your student loans.

Pay off outstanding balances on car loans. That is “bad” debt, tied to an asset that depreciates in value. And depreciates significantly in the first 3 years.

Assuming you’ve met all of the above – congratulations for a great beginning. Now:

If you are highly risk averse – you don’t sleep well at night watching your investments rise and decline, you should think carefully about investing in stocks or any other vehicle that is subject to increases and decreases in value.

If you have difficulty separating emotions from objective financial decisions, you should acknowledge this and ask yourself how that might affect your future behavior making good investment choices.

Be able to explain in one sentence why you bought or are thinking of buying a particular stock, bond, mutual fund, etc., and be able to explain before you buy it what would have to happen for you to consider selling it.

Read everything, be skeptical of everything, and watch out for hidden agendas. It takes time and effort to learn how to eliminate the “noise” found on the television, in books and articles, and on the Internet.

Never act on a “hot tip”, regardless of the source.

Understand the difference between speculating and investing. If you don’t know the difference, you’re already in trouble. Go back to “Read everything”.

Take a look at Why You Need an Investment Policy Statement (IPS) For Investments. And then be able to define your investment objectives and your risk tolerance.

Start small and build on successes.

Consider whether you want or need professional help:  How to Choose and Work With a Financial Adviser.

The post I’ve Got Money to Invest – Should I? appeared first on Thoughts On Mastering The Three Phases of Life.

There are two aspects to the concept of risk tolerance: your ability to take risk, and your willingness to take risk.

Ability to take risk depends on your total financial resources and the impact of potential losses to achieving your financial goals and your desired standard of living. 

Willingness to take risk is very different and comes with a greater emotional component. Confusing the two can lead to financial difficulties.

Assessing your willingness to take risk

To help determine your willingness to take risk, answer these questions honestly, do not answer how you think you ought to answer, but the way you really feel.

Question 1

How strongly do you agree with this statement: Generally, I prefer investments with little or no fluctuation in value, and I’m willing to accept the lower returns usually associated with these types of investments?

1. Strongly agree
2. Agree
3. Neither agree nor disagree
4. Disagree
5. Strongly disagree

Question 2

When some investment advisers use the term risk, they think of it as having two parts: the risk that the value of your investments may fluctuate up and down so much that you worry a good deal about it, or that you may worry that you will not meet your financial objectives. If pressed to choose, which is your greater worry?

1. Worrisome fluctuations in the value of my investments.
2. The possibility of failing to meet my financial objectives.
3. I cannot choose between the two as they are equally worrisome.
4. I cannot choose between the two as I don’t worry about either of them.

Question 3

On a quarterly statement of your investments your balance declined 30% from the previous quarter. How would you likely react?

1. I’m not concerned – I know that investments go up and down in value.
2. I’d be concerned, but wouldn’t lose any sleep over it.
3. I’d be very concerned and would be wondering what, if anything, I should do.
4. I’d be panic-stricken and wonder if I should find another investment adviser.
5. I’d immediately fire my adviser and look for someone else.

Your answers should help you determine whether your current investments are appropriate for you and serve as a basis for choosing future investments.

If you’re considering having an investment advisor manage your investments, it is critical that you consider both your ability and your willingness to take risk before any investments are even discussed. And these factors should be clearly explained to an adviser, with an acknowledgement that he or she understands them and can explain to you the role they played in choosing particular investments.

The post How to Gauge Your Tolerance for Investment Risk appeared first on Thoughts On Mastering The Three Phases of Life.

History of inflation

In 1947, inflation averaged (12-month average) 14.4%.

From 1948 to 1952, it ranged from -1.2% to 8.1%.

From 1953 to 1973, it ranged from -0.4% to 6.2%.

From 1974 to 1978, it ranged from 5.8% to 11.0%.

From 1979 to 1982, it ranged from 6.2% to 13.5%.

From 1983 to the present, it ranged from -0.4% to 9.1%.

Effects of inflation

With 1.9% current inflation, prices double every 36.8 years.

With the 3.2% long-term inflation average for the U.S., prices double every 22.0 years.

With 13.5% inflation as occurred in 1980, prices double every 5.5 years.

In October of the following year (1981), the prime rate hit 18.45%. And mortgage rates exceeded 20%.

Stock bear markets 

In the following 6 months beginning in December 1961, the S&P 500 lost 22.5%.

In the following 18 months beginning in December 1968, the S&P 500 lost 29.0%.

In the following 23 months beginning in January 1973, the S&P 500 lost 43.4%.

In the following 4 months beginning in August 1987, the S&P 500 lost 26.8%.

In the following 30 months beginning in August 2001, the S&P 500 lost 43.7%.

In the following 17 months beginning in October 2007, the S&P 500 lost 50.8%.

Note that to recover from a 50.8% loss, you need a subsequent gain of 1/(1-.508) minus 1 = 103.2% just to break even.

Also note that for long periods of time stock market returns, adjusted for inflation, have been zero or very close to it.  One example: the 24 years from 1968 to 1992. A second more recent example: from its peak on March 24, 2000 to September 21, 2017, the S&P 500 index (SPX) had an annualized return of less than 1% after inflation.

What about the NASDAQ? From 1985 to 2000, it returned zero. Significant stock market gains are made disproportionately in much shorter time periods by a small percentage of stocks, and long-range returns are heavily impacted by severe bear markets like those that incurred in the years 2000-2002 and 2007-2009.

Bond bear markets

From the 1940s to the 1980s, long-term government bonds lost about 60% of their value after taking into account the effects of inflation.

Past and future reminders

The next 30 years are not likely to replicate the last 30 where:

Interest rates have gone from high to low, and low to high.

Government debt went from low to high, and then higher. And then still higher.

Inflation went from high to low, and is rising again.

Consumer debt went from low to high.

Bonds have enjoyed an unprecedented bull market. That is now ended.

One possible future

Rising government debt (deficits) to unprecedented levels. Probability – very high.

Rising inflation. Or deflation.

Rising consumer debt. Probability – high.

A bear market for bonds. Already here.

Reduced or falling GDP growth.

Falling equity prices. Probability of reversion to the mean – very high.

So, what should we conclude?

Never assume the present will necessarily extend unchanged into the future.

If you decide to invest in the market, be clear on your goals and realistic as to their attainability.

Avoiding substantial losses should always be a critical investment goal.

Assuming future stock market gains are likely to reflect past market gains is a really bad idea, especially when doing retirement planning.

Paying yourself first through saving and living below your means are strategies that, unlike the stock market, you can actually control. Ignoring the discipline of a lifetime of saving and relying on future investments gains by themselves is a very risky gamble.

The post Historical Perspective on Inflation and Stock Returns appeared first on Thoughts On Mastering The Three Phases of Life.

IPS defined

An IPS documents financial goals and clearly states how they are going to be achieved.

I’m dismayed to meet people who have never defined their investment goals when they have had money invested with brokers in the past. Goals are critical for making you think about what you are trying to achieve, and they are indispensable for evaluating anyone you have hired to manage your investments. Goals should be reviewed annually and updated when required.

Example of an IPS based on a hypothetical invester

Overall objectives: Ability to retire at age 65 with the expectation of some reduced income afterwards. Retain the pre-retirement standard of living in retirement and never run out money. Allow for the death of one spouse and still meet this overall objective for the remaining spouse. Leaving money to beneficiaries is not a priority.

Approximate net worth (Current assets – current liabilities): $750,000.

Emergency fund: $30,000.

Assets under management: $400,000.

Anticipated investment time horizon: 25 years to retirement, 35 years in retirement (to age 100).

Overall portfolio desired return: annual inflation rate + 4%. A retirement calculation as to what amount would be needed at retirement has not been done, so this return may or may not be adequate for meeting retirement goals.

Risk tolerance: maximum paper loss of 25% in any given year. Note that losses are not incurred unless investments are actually sold.

Investment vehicles to be considered: stock and bond no load mutual funds and ETFs, both passively managed (index) and actively managed, BDCs (Business Development Companies).

Tactical asset allocation: 70%-80% stock mutual funds and ETFs, 20%-30% bond mutual funds and ETFs. Bond portfolios will vary in composition between Treasury bonds, mortgage bonds, corporate bonds, and foreign bonds.

Cost control considerations: No load mutual funds and other investment vehicles with low expense ratios. Excessive trading is discouraged.

Benchmark for portfolio evaluation: Vanguard total stock market (VTI) and total bond market (BND) ETFs.

Tax considerations: tax exempt securities will be considered for any accounts that are not tax-deferred.

Other pertinent information (e.g. needs for liquidity within specific time frames, anticipated medical expenses, estimated college expenses, etc.): None.

Monitoring and reporting frequency: Weekly monitoring and quarterly reporting, via email, of portfolio performance.

Investment Policy Statements should be reviewed annually and updated when required. You should have one if you work with a financial adviser, an investment adviser, a broker, or manage your own investments. If you don’t have one, insist on having one or find a different adviser.

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