In my previous article I explained what I learned from my experience of investing. Or in actual fact, trying to figure out how to invest without a framework. Even with all of my finance degrees and experience of investing for banks I still lacked the secret. And that secret is adopting a goals-driven mindset.
you can only achieve anything worthwhile in life by setting goals
Its strange really. It should be obvious that you can only achieve anything worthwhile in life by setting goals. We do this automatically in many ways. We regularly set goals. That goal might be finding a job, finding a girlfriend or a wife. Or maybe buying a car. Whether we write these things down or not, we work towards these goals with a rational process. If its getting a car we decide what car we want, how we’re going to finance it and what specifications we need (mileage, performance, accessories, etc.). We then examine our budget and assess what we can realistically afford.
Change your mindset to achieve your goals
But many of us don’t do this with finance. Why not? Partly I think it is because of our mindset. If you’re anything like me then the thought of retirement is an unpleasant one. Getting old is bad enough. But I fear getting old and not being able to support myself. Or having to work until I’m 75.
At some point I want to be able to enjoy my life. None of us want to work until we have one foot in the grave. This is not something we want to think about.
our thoughts are dominated by the present
Another problem with our mindset is that our thoughts are dominated by the present. The future is so far away. We think that we have time to change things before it is too late. We imagine that we will actually take the steps necessary in plenty of time to retire comfortably.
You have less time than you think
One of my good friends is a financial adviser. He told me that his most frequent customers are men aged 55 to 60 who’ve just realized how little time they have left. There is now a panic to get enough money together to retire on. None of them want to working packing groceries at the supermarket to make ends meet. And you can forget about leaving something for the children at this point. Your own future is in peril.
Get rid of the denial mindset
I liken it to people who smoke. They know objectively that smoking is bad and that it will take years off of their lives. But they continue to smoke. Why? I suspect it’s because they think that any future consequences are so far off that they can always quit later. Or they simply don’t believe that the bad stuff will happen to them. Or if something bad does happen they can always quit then. I call this the “denial mindset”.
My uncle always felt that he could quit later. And then he got sick. He quit smoking but sadly passed away a year later. With some things there is a point of no return. It works that way with your health and with your finances. The two in fact, are inextricably linked. With bad health you cannot earn good money. And if you don’t have much money you will probably have bad health.
Decide on long-term goals
You may have a family. Probably you feel that you need to ensure they have a secure financial future. Well the first step to ensuring this is make sure that you have a secure financial future. It is important to adopt an investment mindset. And more specifically, a goals-driven mindset. If you have your goals clear and well-defined you can proceed to work towards them.
I was borrowing from the future to pay for the present…
So the trouble I had was that I had a present focused mindset. I was focused on what my money can do for me right now. And worse, I was borrowing from the future to pay for the present. You could say that I had a debt driven mindset. This is related to the denial mindset in that like retirement, I felt that I could always pay off the debts later.
Retirement is a key goal
So I decided on what my long-term goals were. Obviously planning retirement was a lot more long-term than buying a new car. Fundamentally for me, making sure that I was comfortable in retirement was the primary goal. So I sat down and drew up a budget for the future me. What would I need to pay for in the future? What would my daily expenses be?
I calculated what these would be on annual basis. From there I knew what percent return I needed from my portfolio and therefore what size portfolio I needed. Once I had determined the required portfolio, I decided when I want to retire. It would be nice to retire a little early so I decided on 60 years old.
Now given my age I knew how many years I had to accumulate my little fortune. Given my current level of savings I could see what return I needed to earn in order to reach my retirement goal. This was my return objective.
I was already putting about 10% of my salary into a pension but at this stage it would not be sufficient. However, normally our salary increases over time so I knew that my contributions would also increase over time.
Asset allocation
The next thing I did was proceed to allocate my pension investment to various assets. I had noticed that many people I worked with simply put their pension account in the most conservative account and then ignored it for decades. The trouble with that is that it may not be appropriate for you. This is not an investment mindset. It is a savings mindset. And if you look at savings accounts they are earning negative interest at the moment. This will not help you reach your goals.
Assess your risk tolerance
You may be able to tolerate more risk. What I did was think very carefully about the riskiness of my portfolio and how much risk I could tolerate.
When it comes to assessing your risk tolerance you should consider:
- How much wealth you have
- What the source of your wealth is
- How much time you have to achieve your goal
There are more considerations of course but these were the important ones to me at the time. Now whether you are wealthy or not is somewhat subjective. You may not feel particularly wealthy compared to Bill Gates but compared to a kid fresh out of college you’re probably doing fine. In my case, since my portfolio did not already provide enough income for me to retire, I considered it to be small.
Source of wealth is important. If you have accumulated your wealth through passive saving you may not be familiar with risk-taking activities. On the other hand if you’re a entrepreneur then probably you are very familiar with risk taking and can probably tolerate more risk. In my case, I had been managing risk for banks for years. I also had a deep understanding of investment from studying the CFA curriculum.
Since I had a long-time horizon (20 years) I decided that based on this and my experience of investing I had above-average risk tolerance.
Playing it safe is playing it dangerous!
You must also consider that if you decide to play it safe that you may not earn enough return to achieve your goal. But you have an easy answer to this because you can compare your return objective to what you are currently earning and you will immediately know if you are in danger of not meeting your goal. Both action and inaction have risks. This is how the goals-driven mindset helps you make decisions.
So now that I had both my return objective and an understanding of my risk tolerance I could decide how to allocate my pension portfolio. The most important risk decision an investor can make is how he decides to allocate his portfolio.
Diversify with stocks and bonds
Generally speaking stocks are riskier than bonds. We measure risk by measuring its historical volatility. Stocks tend to be three times more volatile than bonds. Hence you might say that stocks are three times riskier. By volatility we mean that stocks experience greater swings in value than stocks. So stocks are more likely to go up in value more than bonds.
But stocks are also more likely to go down in value. So if you mix your portfolio with stocks and bonds then the bonds can smooth out the volatility of your overall portfolio. Another important point is that when stocks go down in value bonds tend to go up.
…bonds help to diversify your portfolio…
Bonds are negatively correlated with bonds. Normally. But due to Fed intervention this relationship is starting to change. But at least for now, bonds help to diversify your portfolio, reduce the risk and smooth out the returns. There are other assets you can use to diversify your portfolio. I’ll explain more about those in later articles.
So based on this, I had a healthy allocation of bonds to my portfolio. Some advisors suggest somewhere between 40% to 60% stocks and the rest bonds should work for most people. But obviously the precise allocation depends on your personal situation. Personally, given my objectives I felt that 60% stocks and 40% bonds was appropriate for me.
So I went into my account and made the allocations. Pretty much I could leave it alone and wait for the annual statement. The contributions would go in automatically and the portfolio would generally rise in value from year to year. It might go down during periods of high volatility or stock market crashes but since I have a long-term view, I am not concerned with short-term losses.
The trouble with pensions
All the same, a big problem with pensions is the lack of accessibility. If you have some kind of emergency (like losing your job – I’ve lost my job three times!) you may need some money. So as well as having an investment portfolio with retirement as your goal you should consider an emergency portfolio. This portfolio should sustain you for about six months. Maybe more depending on your situation.
Savings accounts are a waste of money
For my emergency portfolio I decided to buy gold. I bought gold coins and I bought gold in a gold account. Some people prefer to use a savings account for this purpose. I advise against this for many reasons. For a start savings accounts pay you hardly any interest. When you include inflation, the interest is negative. So this is a guaranteed loss every year.
Next, we all know about the bank failures of 2008. Do you really want your money in an effectively insolvent institution? If that bank goes down it will take your savings with it. And there is no guarantee that the government will bail out your bank. Just ask the former employees of Lehman Brothers.
Finally, do you really want to reward institutions that nearly brought down the global economy with your business? By earning negative interest, you are effectively paying for the bail-out. This bail-out of irresponsible businesses. Paid for by responsible savers like yourself.
…gold… acts as an inflation hedge.
Now gold on the other hand acts as an inflation hedge. It tends to go up with inflation. Also, depending on what period you look at, it sometimes outperforms the S&P 500. There is very little chance of you losing all of your money in gold. Gold is used in many industrial applications and has constant demand. It is also desired for jewellery around the world.
Typically, when you buy gold coins you don’t pay capital gains tax. This is because they have a face value which is determined by the government. But the gold content of the coin allows you to sell it for the market price of gold.
Gold is more effective than a savings account
When I lost my job my gold pretty much saved my life. I hated to sell it. It’s an interesting mindset. When you own gold you never want to get rid of it. For this reason I think that it’s a more effective way of saving than a savings account. But unfortunately, I did have to sell some of it to pay my living expenses.
This is why you don’t want all of your investments in a pension account. There are great advantages. You have tax benefits and matching contributions from your employer. But it can be difficult or even impossible to withdraw money for short-term liquidity issues, like unemployment.
Summary
What have we learned?
- Adopt a goals-driven mindset
- Identify clear, achievable goals
- Prioritize your goals
- Have different portfolios for each goal
- Determine your return objective
- Determine your risk tolerance
- Choose appropriate assets
- Review your portfolios based on changes in your personal circumstances
In my next article I’ll talk about how this changed my life and how it can change yours. But if you need help to implement these steps yourself, let me know. If you take a minute to tell me a little bit about your situation I’ll be able to point you to the best possible free resource to help you get started now.
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