How Does Investment Management Fit into Financial Life Planning?
After describing the differences between financial planning and financial life planning in a two-part series (read part 1, read part 2), I want to turn to the sexier aspect of mapping your financial future: investing. At least the media will have you believe that it’s the more exciting aspect of having a financial plan. They have created the impression that investing is all about picking today’s hot stock—or worse, hot stocks by the minute. Intra-minute charting analysis CNBC? You’ve got to be kidding me. That’s not really investing, that’s stock picking—gambling’s ugly cousin.
I want to explain what investment management really is and how it can magically make you sweet dough while you sit all day and binge the latest season of Stranger Things.
I mentioned in part 1 of the financial planning vs. financial life planning series that a lack of an intentional financial plan is still a plan, just not a very good one. The same can be said for investing. If you haven’t formalized a plan for how your assets will be invested, then they’re invested according to the “I don’t really care about this” formula. There’s actually an industry term for this approach called naive diversification. Don’t be naive.
So what makes a good investment plan? While there is nuance among professionals about how they implement this, they all have these basic components.
Asset Allocation
The first step of investing is asset allocation. This means that you intentionally select what percent of your investments will be allocated to stocks, bonds, cash and other asset classes (the stuff you actually invest in). This allocation is primarily driven by two factors: your risk capacity and your risk tolerance.
Risk capacity is an objective measure of your ability to take investment risk. It incorporates, among other things, your goals, the time to reach them, your current assets, how you’ll be withdrawing (one time vs periodic payments), and projected rates of return. This analysis is primarily done by mathematical analysis and is pretty much black and white.
Risk tolerance, on the other hand, is your subjective view of risk. It is about determining your willingness for risk based on the emotions we all feel about losing money in the market. Do market drops make your own stomach churn? Does losing 30% of your account value make you want to stick your head in the sand?
Through a combination of art and science (experience matters people) you put these two together and voila: asset allocation.
Diversification
The next step is being diversified. Say you have a 70% stock, 30% bond asset allocation. Now you have to choose what goes into that 70% and 30%. A proper investment plan will include a whole bunch of securities that will give you exposure to all areas of the market. For example, within the stock allocation you can choose among U.S. and international, large cap and small cap, growth and value. You basically want them all. Why? Because each one of these acts a little differently than the others so when one is down, the other might be up. And since you don’t know which will do what, just be safe and choose a bit from each one.
Here is where you also decide if you’re going to be a stock picker (and treat your investments like a game of blackjack) or a long-term investor. It’s difficult to create and manage a diversified portfolio of individual stocks and bonds. Lot’s of buying and selling leads to unnecessary trading costs and potential taxes. For this reason, the majority of assets tend to be invested in ETFs (exchange traded funds) and mutual funds.
Rebalancing
You’re all set with your asset allocation and you’re diversified. Set it and forget it, right? Nope. That asset allocation you chose is like a 3-year-old kid who can’t sit still. It’ll change based on market fluctuations. Stocks go down and bonds go up? Your 70/30 allocation is now 62/38. If you don’t monitor it and get it back to 70/30, it’ll be all over the place going forward. And now you’re back to the “I don’t really care about this” plan.
Why Investment Management is so Important
So what does this all mean you ask? Well, here is a very basic, hypothetical example. Assume you decide that Stranger Things is the shit and you want to binge watch that for the next 25 years. Further assume that a 70/30 portfolio will return what it’s returned historically since 1926, which is about 9.4% a year. With the help of your financial adviser, you invest $50k in this portfolio based on the principles above and start binging. Well, when Eleven finally kills every last, damn demogorgon in season 29 and you check your portfolio, you discover that your balance is now $472,500. For reals. And all you did was absolutely nothing. Well, not exactly, you did you one thing: you decided to be intentional.
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