CHAPTER
2

Defining Your Investment Goals

In This Chapter

• Is investing right for you now?
• What types of investments might work for you?
• Defining your short- and medium-term goals
• Setting longer-term goals

Many investment decisions will be rooted in your personal goals and timetable, so in this chapter, we’re going to define what they are and build a timeline for achieving them. Before setting off on any adventure, you need to have some idea of where you want to go, how long it will take, and how you’ll know when you’ve arrived.

Getting by Versus Getting Ahead

If you’ve worked through the percentage-of-income exercise I suggested in Chapter 1, you know what your spending and saving goals should be. If you really have no idea what you’re spending, consider employing the assistance of some type of budget software or app. You may find that you spend more on certain categories than you think. Set up two categories, fixed and discretionary expenses, or whatever works best for you and your situation. Commit to using the software or app for at least 3 months to capture your expenses, including any irregular ones.

Tip

If saving money sounds somehow punitive, try thinking of savings as your stash for increased spending in the future. You could also change the way you think about your accounts. Instead of your “emergency fund,” think of it as your “peace of mind fund.” Rather than “investment savings,” consider it your “wealth builder war chest.” Instead of your “401(k),” it could be your “job freedom account.” Whatever works for you.

If you’re just getting by—or not even getting by—you don’t have enough money to invest just yet. What you should be investing in at this point is yourself: learn to create and manage a budget and read all you can to improve your investing knowledge. You can also start to ask yourself some important questions. We’ll explore these questions in the rest of this chapter.

What Types of Investments Interest You?

As you read through this book, think about the investments that appeal to you. Are stocks or mutual funds an appealing investment for you? Do your research, pick out a few stocks you’d buy if you could, and start following them. This is called paper trading, and it can prepare you for the ups and downs of what happens to your money when it’s invested.

Definition

Paper trading is the process of choosing a stock or even a whole portfolio and tracking its performance on a regular basis. Keep records of what you buy, what it costs to purchase, and its variations in price. You can set this up in your Quicken software or at Morningstar.com or other financial sites. You don’t actually buy the investment, but you observe it as if you had. This offers you a good way to understand performance and your reactions to changes in value (your risk tolerance—see Chapter 4).

Do you want to invest in real estate? Start scanning the for-sale listings and driving by properties that would interest you. You’ll learn all about neighborhoods, curb appeal, and property size. Create a watch list of specific properties to see what they sell for versus what the asking price was, how long they were on the market before they sold, and so on. Attend open houses—any real estate agent will tell you they get plenty of nosey neighbors, so you won’t offend them. Ask the Realtor plenty of questions at an open house—you’ll figure out which Realtors are knowledgeable and maybe find one to work with in the future.

We’re all eager to jump into investing so we can make money. However, doing some research and working through a simulation can help you prevent some of the real-life losses that go hand in hand with lack of experience.

What Are Your Short- and Medium-Term Goals?

It’s good to have dreams, but when it comes to investing, think of dreams as goals. Goals encourage you to think in specifics. When you know exactly what you want, you can rank your goals based on how much money you have now and how much time you’ll need to work your investment strategy, as different time frames require different strategies. How fast do you need your money to grow? How long can you wait out market downturns?

Determining What You Need

Why do you want more money? Do you want to buy a house? Cover the expenses involved in adopting a baby? These and other short-term (fewer than 5 years) goals require you to think about specific costs. How much money do you need, by when?

You may choose to accept more risk with your investments in the hope of achieving a goal sooner—but only if not achieving the goal in your desired time frame is acceptable. For example, if you want to buy a house within 5 years, you could invest in stocks, knowing that stocks fluctuate more than a safer investment such as bonds. Because of a stock’s fluctuations, you might achieve the goal sooner—say, in 3 years—but if the market turns against you, you might need to wait longer than you’d planned—perhaps 6 or 7 years.

If, on the other hand, a goal is particularly important to you, such as covering the expenses of adopting a baby, you might need to stick to a more rigid time frame. In this case, you will want to choose steady investments that can build a reasonable, more predictable (but lower) return with less chance of loss and easy ability to cash out in a specific period (for example, diversified or balanced mutual funds or even bond funds or cashlike investments).

If you have a spouse or can move into your parents’ basement, you may need far less than someone who depends on a single salary for support. (Steve Jobs built the first Apple computer in his parents’ garage.) If your business will require capital for producing a product, renting office or warehouse space, and so on, it’s essential that you work through the production of a business plan to know how much you’ll need.

Tip

The U.S. Small Business Administration (sba.gov) offers many courses available online and in person to help you develop a business plan and budget, plan for specific types of businesses, and learn to apply for loans. Invest your time in learning how to give your business idea the best chance of success.

Where to Put Your Money

Money earmarked for short- and sometimes medium-term goals should be held in safe investments like savings accounts; certificates of deposit (with a term consistent with when the money will be needed); money market funds; possible short-term, high-quality bond mutual funds; or (for those with longer or more flexible time horizons) possibly balanced mutual funds or a small selection of diversified mutual funds. The latter two types of investments may carry more possibility of both loss and gain. (See Chapter 10 on mutual funds.)

Warning

Money you will need in fewer than 5 years should not be considered available for investing. A serious economic downturn during the period you need to liquidate the funds can cause you to come up short on business capital as well as lose money on the investment itself. If you rack up some serious debt on a credit card trying to stay afloat, you’ll be searching the internet for bankruptcy advice, not investment advice.

Different short- and medium-term goals require different investment strategies and different mixes of investments and levels of risk tolerance. The loftier the goal you have for net worth, the more you should look to a combination of strategies to build it and the earlier you should start.

Tip

In 2013, Forbes analyzed how 400 billionaires made their money. Of the 400, 127 inherited it. Of the rest, here are the top 10 ways they made their money: investments, technology, real estate, fashion and retail, media, food and beverage, energy, health care (inventions and patents), sports, and manufacturing. Unless you’re really good at sports, you’d better start investing, buying real estate, inventing something, or starting a business.

You might have other longer-term goals as well, such as achieving a specific net worth or leaving an inheritance to your loved ones.

Amassing Enough to Retire

What’s enough money to enable you to retire? How do you know how much you’ll need? There are numerous answers to this question—and more questions. What do you earn now? Is it enough to make you feel comfortable? Would you like to live better in retirement than you do now?

Are you saving anything now, or are you in debt? Also, how old are you? If you’re at the beginning of your career, you may be expecting to earn a much higher salary by the time you retire. On the other hand, by retirement age, you probably won’t be raising children or paying for college tuition. And in retirement, you won’t be paying Social Security taxes, and perhaps your income taxes will be lower. (But don’t bank on it.)

To determine how much you need to retire, take your current earnings, subtract what you’re currently saving, and add any credit card expenses you don’t pay off every month (that’s what’s beyond your current means). Now divide that figure by .04 (a rough estimate of what you can safely withdraw from a portfolio and expect it to last through 30 years of retirement). If you want a higher spending level in retirement, substitute your desired income level and divide by .04 to get the amount of the investment portfolio you would need to generate that income.

Let’s say you’re 35 years old, making $85,000 a year, and saving nothing. To replace that income in retirement, you’re probably going to need 100 percent of that amount to live the same lifestyle. (If you anticipate that your expenses might go down a bit—say, less in taxes, lower commuting expenses, or a smaller clothes budget—you might reduce that percentage a bit.) Let’s say you’ll get $2,000 a month ($24,000 a year) in Social Security. So your portfolio (workplace retirement, outside investments, IRAs) needs to be large enough to withdraw $61,000 a year, or at least $1,525,000. Is that a terrifying amount? But wait—that’s all in today’s dollars. We’re not factoring in inflation over the 30 or so years you will continue to work. The good news is, we’re also not factoring in the return you’re going to achieve on your investments. You won’t have to save it all.

Tip

How long will it take to double your money? How long will it take inflation to erode your money’s spending power? The formula for estimating this is 72 divided by rate of investment return (or inflation). For example, if you have $1,000 and are paid a 3 percent dividend: 72 ÷ 3 = 24 years to double your money. If your $1,000 earns 8 percent: 72 ÷ 8 = 9 years to double your money. How long before inflation erodes your buying power? With 3 percent inflation, in 24 years, your $1,000 will buy what $500 buys today. This isn’t precisely the way to calculate inflation-adjusted returns, but it gives you an idea of how investments need to out-earn inflation.

Accumulating significant wealth generally requires saving a high proportion of your salary to generate enough excess to invest. This may entail being very frugal or focusing on continually improving your salary while living below the increases. You also might need to be much more willing to make risky investments that might have a big payoff (individual stocks) or ones that require personal investment of your time and effort, like direct real estate investment or starting a business.

As with all wealth building, you somehow must generate more than you spend. If you’re in a hurry, you don’t have time on your side to slowly build so you must figure out ways to generate investment money more quickly. (For more information, see Chapters 11 and 14, on stocks and investment real estate, respectively.)

Having Enough to Leave an Inheritance

People vary widely in their desire to leave an inheritance to their family. Whatever your feelings on the subject, I can practically guarantee your children will be hoping for something to remember you by.

Some people feel that after raising their children, and possibly putting them through college, they’ve done enough and intend to spend it all. Or as one person told me, “We want enough money to last us for one year past our lifespan.” Other people want to leave as much as possible to their children or other relatives (and usually as little as possible to the tax man), or would like to make a significant bequest to charity.

If you achieve significant wealth (more than about $5 million under current federal tax policy), you’ll need the help of a financial planner and an estate attorney to structure your estate for tax efficacy. Less than $5 million and your ability to leave a legacy may be about how you insure yourself against the risks of old age and disaster. Also, check your state’s estate limits. Some states tax smaller estates than the federal threshold.

Tip

In a study conducted by the Institute on Assets and Social Policy, among households with positive wealth growth during the 25-year study period, the number of years of homeownership accounts for 27 percent of the difference in relative wealth growth between white and African American families, the largest portion of the growing wealth gap. The second-largest share of the increase, accounting for 20 percent, is average family income. Highly educated households correlate strongly with larger wealth portfolios, but similar college degrees produce more wealth for whites, contributing 5 percent of the proportional increase in the racial wealth gap. Inheritance and financial support from family combine for another 5 percent of the increasing gap.

What Is Your Definition of Wealthy?

Another way to determine your investing goals is by defining wealth for yourself. When would you consider yourself wealthy? Consider the possible levels:

• Secure When your inflow reliably meets or exceeds your outflow
• Wealthy When your inflow always exceeds your outflow, and you can choose luxury (at least sometimes) over practicality
• Filthy rich When your inflow (especially from assets) is more than you can spend in your lifetime

Many of us, at least by retirement, would be very happy to reach the first level. But note that there are two components to every level of wealth. Not only do we strive to improve what’s coming in, by improving our income and investment return, we also can improve our wealth by managing our outflow.

At the point of retirement, my parents lived in a modest, paid-off home, drove their cars for about 8 to 10 years (always well maintained), and ate out 3 nights a week—nearly always at the senior special. They took a 2-week vacation every year, and they lived on Social Security and the income generated by a $300,000 portfolio. Mom made it to age 90, and Dad to 96. They left a substantial chunk of their portfolio intact, did anything they wanted (which was modest), and had enough to handle their health care in their last years. They were, most certainly, wealthy. And as children of the depression, they felt very well off, if not wealthy.

On the other hand, I see people who make more than $250,000 a year, have home-equity loans in addition to their mortgage, carry significant credit card debt, and have to cash out their IRAs to pay for their kid’s college. By my definition, they’re not wealthy—in fact, they’re on their way to being broke.

If you have any aspirations to build wealth, it’s not so much about what you earn as about what you can hold on to and then grow through well-chosen investments.

People are more likely to achieve, if not their actual goals, then at least some progress toward them, if they have a measurable goal. “Saving as much as possible and making as much as possible on my investments” is not a measurable or satisfying goal because you will never know when you achieve it. So right now, think about how much you would need to have as income to achieve each of these levels of wealth. If you estimate that you can safely withdraw 4 percent of the value of your investments each year, how much would you need to have invested to achieve each level? (You can include your work earnings if it makes you feel better, but I don’t think you’ll feel wealthy until you really don’t need to work.)

For any and all goals, write down a goal you can measure and an aspirational goal for achieving them. Gather the best advice you can, and think through what tools (investments) are appropriate to use. Of course, you might need to revise your goals periodically as you change or if you achieve the goal. Some may be tweaked, and some may even be discarded. Then, you’ll begin again to set new goals.

The Least You Need to Know

• Start thinking about what types of investments interest you, and consider starting a paper-trading account.
• Define your short- and medium-term financial goals as specifically as possible, and define the period of time you will need to achieve them.
• Keep your eye on your long-term goals. They’ll take longer, but you should monitor that you’re making progress over time.
• Your goals can be mundane or lofty, but to achieve them, you need a plan and a measureable way to know if you have met them.
• Know what your own personal definition of wealth is.