Broker Check

Long-Term Financial Security Begins With Goals and A Plan


by Howard Hook, CFP®, CPA

As published in The Princeton Packet, May 23, 2012

The recent euphoria surrounding Facebook's IPO caused me to think about why people invest. The most popular answer received in an informal poll I took among my Facebook friends was “I invest to make money.” When further asked about why they want to make money, the typical answer was the same one my 6-year-old son gives when asked why he wants to stay up past his bedtime: “Because I do.”

Despite the responses, it is vital for an investor to go beyond the surface and truly understand why they want to make money. Otherwise, they never will. They'll never be able to sell an investment that has made money because they will always assume it will make more. Conversely, they won't be able to sell an investment that has lost money because they'll be hesitant to sell it, thinking it will go back up.

Think about it. Suppose an investor invests $1,000 in a mutual fund which six months later is worth $1,250. Should the investment be sold now for a 25 percent gain? Or should they let it ride hoping the investment continues to rise in value? An investor may be willing to risk $1,000, but what about investments that comprise much larger portions of a person's assets, such as a 401(K) account. Making the wrong decision with those assets can severely damage one's financial security. Yet many people make investment decisions without first understanding the reason why they are investing in the first place.

To make better decisions, a goals-based approach to investing should be employed.

A goals-based approach starts with writing down goals and dreams, which typically fall into three categories. Short-term, intermediate and long-term goals may involve different investment accounts. For example, the goal for your 401(K) plan could be for retirement while the goal for money in your savings account could be a new car purchase.

Once goals are determined, the next step is to calculate how much money is needed to reach each goal. For retirement, it might mean preparing a retirement projection. For saving for a child's college education it can mean projecting out the future cost of college and then figuring out how much is needed to reach that goal.

Obviously, the rate of return from investments is an integral part of the success or failure of reaching these goals. Over long periods of time, a portfolio consisting of well-diversified equity investments will likely outperform a portfolio with fixed income investments. Examining one's ability to withstand a lot of volatility in their portfolio allows for decisions to be made regarding how much of an investment portfolio is allocated to equities. However, in the short term, equity returns may be more erratic than bond investments and certainly cash investments. Those that cannot withstand the ups and downs of their equity investments may want to adjust their goal, allowing them to reduce the amount of equities in their portfolio.

There are other areas in everyone's financial life that should be reviewed as well when using this goals-based approach. How will the ability to reach a goal be affected if the investor or a family member suffers a catastrophic event resulting in loss of income due to a disability, premature death or income garnishment due to losing a lawsuit? What effect will this loss of income have on assets, many of which have been earmarked for other goals which now may not be achievable?

Different goals have different tax implications so understanding how best to save for those goals in a tax-efficient manner is crucial. Most people know that taking money from a 401(k) plan to pay for a new car or even a child's college education is not the best way to save for those goals and is not very tax efficient. A goal-planning strategy may call for limiting distributions from retirement plans and instead drawing money from more tax-efficient accounts. This allows for longer tax deferral in the retirement accounts and less tax paid from the non-retirement accounts.

Finally, coming to an understanding of how much money one wants to leave to heirs can have a significant impact on an investment strategy. Those unconcerned about leaving any assets to heirs may be more aggressive with their investing because the money will not be needed to support anyone else. However, leaving a financial legacy lengthens the time period for which withdrawals will be needed and thus more conservative investing may be warranted. Interestingly enough, this does not mean investing less in equities (it actually increases the need for more equities in your portfolio). It just means investing in less speculative investments such as IPOs.

The goals-based approach to investing allows for the selling of an investment once it reaches a certain price because selling it will be aligned with goals. Similarly, selling the investment that is losing money and reinvesting the proceeds in something with better prospects of making money will also be easier because it too will be aligned with your goals.