As discussed in a previous column, I operate on the simple philosophy that any investment should be a direct solution to an individual’s personal problem. If a person had no personal financial problems, it would be foolish for him or her to expose his or her money to risks if they had nothing to gain.
Most people operate with the philosophy that their principle goal when making any investment is to make as large a profit as possible within an acceptable range of risk. Other people carry this philosophy a step further and try to implement a system of asset allocation to diversify the risks. The theory of asset allocation attempts to predict the future economic cycle, inflation’s rise or fall, and then creates an asset allocation mix to use on investment assets.
While I feel that there is a lot of merit to this system, it does not focus on the real problem. Why are you making investments in the first place? What are you trying to achieve? An investment made just for profit is like a boat without a rudder. While it may be completely seaworthy and sound, it cannot be directed to any specific location.
If investments should be made as a direct solution to an individual’s personal problems, wouldn’t it make more sense to first identify each specific problem and then find the best investment solution? Investment types are designed to offer different benefits. Some are designed to be extremely safe and only produce an annual income while offering no opportunity for growth. Others offer the potential for a mixture of both income and growth, while still others concentrate solely on growth and have little or no opportunity for income. Obviously, each investment area offers varying potential degrees of risk and reward.
Therefore, it would be best if you operate on the concept of first identifying the specific problem the investment is trying to solve and then selecting the best investment solution available. Additionally, instead of applying a global asset allocation philosophy to your investment portfolio, you should focus your asset allocation formulas to each specific need at hand. This way each investment problem will be addressed with the best, well-diversified options available.
Let me give you an example on how this philosophy works. Let us say your goal for making an investment is to build the funds needed to help your children or grandchildren with their education costs.
The first step in your education planning should be deciding the actual number of years your child(ren) will attend college and the current annual cost of the assistance you wish to provide. The next step should be to factor in an inflation rate to decide your child(ren)’s actual future capital needs. Once calculated, a sinking fund should be calculated which assumes an annual yield on your newly invested funds that will accomplish your goals. Finally, you need to determine the annual investment amount that need to be invested each year to build the appropriate sinking fund using the previously described factors.
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There are several things on which to focus to resolve this goal. First, any investment vehicle(s) that might be considered should be viewed with a predominate emphasis toward “moderate growth” as opposed to “speculative growth.” Choosing a more speculative potential yield would obviously reduce the annual funding requirements; but it would also substantially increase the chance for an overall loss. Therefore, investments selected for this need should be more conservative in nature.
It is important to note, however, that you not select the most conservative investments available as their yield would be the lowest and this would drive the cost of funding this program to an unnecessarily high level. Therefore, it is suggested that you use a philosophy of selecting investments that offer a moderate growth potential with an equally moderate risk.
Other factors to be considered are the required minimal time factor necessary for an investment to perform to the desired standards and the predominate need for liquidity. If funds from an investment need to be withdrawn within a two-year period, there may not be enough time for the investment to perform. As a result, this particular criterion is not intended for anyone with an investment-funding requirement of less than two full years.
The final factor to consider is “investment diversification.” In this regards, it is not advisable to “put all of your eggs in one basket.” The odds for substantial loss can be dramatically reduced using a diversification philosophy. However, if you only have one egg to invest, you should not break that egg up to put the shell in one basket and the white and yoke in another. As a result, if your monthly investment needs in this area are under $300, then investment diversification is no longer advisable; you should invest all of your money in the best option you can find.
Focusing on the above-described parameters, there are many investment alternatives. Real estate programs, annuities, equipment leasing programs, hard assets, oil and gas programs, mutual funds, etc., just to mention a few. However, if you evaluate each potential investment based on your actual desired needs, most can be eliminated due either to lack of liquidity, risk factors, or annual investment “minimums,” which exceeded most people’s education funding requirements.
For many investors that are not well-educated in a specific investment area, one of the best solutions for this particular problem of investing is mutual funds, because professionals manage them. Another benefit of selecting mutual funds to solve this need is that you will not have to spend a substantial amount of time managing this portion of your investment portfolio.
Obviously, you do not just want to pick a fund out of the thousands available without some additional considerations. Some parameters you may want to consider to help in narrowing down the field of options are that any potential fund considered should have performed in the upper 25 percent of all funds available; have at least a 10-year track record; have at least $500 million under management; and have performed statistically well in both “up” and “down” markets.
Based on this example, you can follow the same processes described above for any other goal for which you might invest to build assets such as your retirement.