When people find out that I’m an investment advisor, the first question they often ask is: What should we invest in? But when I look them straight in the eye and ask them why they are investing, for how long, and how much risk they are willing to take on, they become very impatient.

I guess we all want to jump right to the “good parts.” But investment management is a continuous process where the goal must define the plan.

Planning Process Overview

Many professional investment advisors divide the planning process into five clearly defined steps as seen at the right of your screen.

Actually, we all know that the steps cannot be separated, and instead of a straight line, we should think of the process as a continuous loop. But the five-step process will give us a good framework for discussion as we begin to develop investment strategies.

A clear definition of objectives, time horizon, and risk tolerance goes a long way toward suggesting the appropriate investment strategy. The better we can define our objectives, the better plan we can craft to meet them. The more precisely we can define our goals, the better plan we can design to meet them as well. It’s not enough to say: “I want to make a lot of money,” or “I don’t want to take a lot of risk.”

Of course, in real life you might normally be expected to have several distinct financial goals, each with different parameters. A young family may be simultaneously saving for a down payment on a home, retirement, and college-education expenses. An older couple may be focused on retirement and estate conservation. Each objective may have different time horizons and risk parameters.

Because of the nature of my practice, and because most long-term investing tends to be for retirement, I’m going to slant the remaining discussions toward that goal. However, the lessons we learn can be applied to any investment goal.

Setting Monetary Goals

Setting monetary requirements for each goal is a straightforward process and can be outlined according to the chart below:


  • As a first step, inventory your resources, including pension plans, social security, other existing investments, and real estate. Add in any other planned investments.
  • Project your income needs and capital needs in today’s dollars.
  • Add an appropriate inflation adjustment. This will give you a target in inflated dollars.
  • From this information you can determine your minimum required rate of return on your current assets and planned investments.
  • This required rate of return must be feasible and attainable, and within your risk tolerance.

If the rate of return isn’t feasible, you better go back and make adjustments in your lifestyle or increase your planned investments. Based on what we know about long-term returns, I wouldn’t be very comfortable if your retirement strategy required an 18% return on your portfolio. It’s just not likely that you will be able to find a combination of assets which will reliably deliver that rate of return.

Often investors feel driven to take excessive risk when they are unable or unwilling to invest enough to meet their goals. They become prime targets for scam artists with inflated promises. The elderly often become victims of fraud when they see that their existing assets will not be enough to support their lifestyle. Then they lose everything.

Finally, we can design a portfolio with an expected rate of return adequate for your needs. Most of you will find that you must develop a required rate of return higher than bonds and savings can generate. The next question is: Can you live with the risk required to meet your goals? If you can’t, we have to go back and adjust your lifestyle or increase planned investments.


Software Help

If this sounds like a very complicated exercise, relax. We have software to do these calculations. Many available programs are very powerful, and allow for instant comparisons of alternative scenarios. You will be able to see instantly if your assets will support your desired lifestyle, and what rate of return is necessary to keep you from running out of funds. We can also determine how much risk you will have to assume to get the desired rate of return.

Vanguard, for instance, has a very sophisticated retirement planner. This program will guide you through many of the items you must begin to consider as you build your plan. It makes quick work of budgeting, social-security forecasts, inflation adjustments, assets available, time to go to objective, rates of return required to meet objectives, and risk required to meet rate-of-return requirements. You can build in known expenses like college or a new boat, and expected future receipts like sale of a home or inheritance. You can see the effects of tax-rate changes, and play “what if?” with investment returns or risk levels.

Because this software does such a great job of pulling together so many elements of the problem, and graphically illustrating the possibilities, it may be about the best $17 you will ever spend. Quicken just announced a retirement planner, and Microsoft Money won’t be far behind. Other mutual-fund companies provide software now or will soon. Several freeware and shareware packages are available on the Net.

Your age and financial situation will impact how you set your goals. It’s silly for 25-year-olds to attempt to exactly forecast their retirement budget. At that age, few of us know how our lives and careers will develop. In addition, the very long time frames mean that if our estimates of rate of return, inflation, or expenses are off just a little, the resulting error will be enormous. But while our future may be a blank sheet, the need to provide for it is not.

Putting Time on Your Side

As we saw in the last chapter, it is vital to begin investing as early as possible, and small periodic savings early in our career will grow to really meaningful balances given the magic of compounding. So, 25-year-olds may be content with a goal of saving 20% of their gross income, obtaining a rate of return of at least 6% over inflation, and avoiding taxes on their investments. If they continue this discipline throughout their careers, they may reasonably expect to attain financial independence and security.

The idea of saving 20% of your gross pay may seem a little revolutionary to many of today’s consumers. Since we’re showered with credit cards, it may be difficult to resist the temptation to spend, spend, spend. But keep in mind that no matter how little you think you earn, many others would be happy to have 80% of it. If we don’t establish the discipline to live on less than we make, no one else can do it for us, and no amount of investment advice will help.

All investors with access to a tax-favored retirement plan offering a current tax deduction, as well as tax-deferred accumulation for the life of the plan, should take maximum advantage of this opportunity. It will reduce the real cost and increase the benefits of your hard-earned investments. By providing both a carrot (in the form of tax deductions) and a stick (in the form of tax penalties for early withdrawals), retirement plans increase the chance that money will be saved, and that it will be used for the intended purpose.

Many people find it helpful to put their goals in writing, and actually sign this document as a contract with themselves. This gives them an extra sense of commitment. As I’ve said before, if you’re anything like me, you need a system to enforce discipline when the child in you craves another toy.

As we grow older, we should be better able to get a handle on our career progression and lifestyle. By age 50, it begins to be possible to forecast retirement requirements. Most of us have some fuzzy idea about where we would like to live, in what style, what size boat we want, how many children we have left to put through college, and other needs. By this point, we also have some assets to inventory. We can begin to put numbers on our requirements. The assets available, the extent of our needs, our past investment success, time remaining to retirement, future investment levels, and required rates of return can begin to be estimated.

Nest Egg

Hopefully, we will have accumulated a good-sized nest egg. This nest egg will continue to grow, and along with planned additions provide for our future security. If we have no nest egg, it’s not too late to begin a serious investment program.

As we approach retirement, our planning can become more refined and precise. All along the way we will need to adjust constantly. We may develop new requirements, or need to incorporate new research into our plans. A good plan is flexible, but focused and disciplined at the same time.

Investors must not assume that because they are retired, their need for income will automatically decrease. Many “young” retirees (say under 75) actually find that they need more income than they did before retirement. Because of increased free time, they can now travel and pursue other interests which were deferred during their working and child-rearing days. In any case, it’s probably not realistic to plan for less than 75% of your pre-retirement income in “real” or inflation adjusted dollars.

Somewhere between age 70 and 85, retirees may begin to limit the number of trips they take and reduce their income needs. However, about age 70 many retirees find that their income needs increase again as their health-care and long-term-care expenses increase.

My own experience with retirees bears this out. Few choose to sit in a rocking chair on the porch and drink iced tea all day. A friend of mine recently invited me to jog with him one morning at a fishing camp. I run several miles three to four times a week, but after a few miles, I had to quit while he continued on for another three miles. After breakfast, we went fishing for the entire day. After dinner, the retiree led an evening hike, followed by card playing well into the night. The next morning, he was up early to go fishing again. His age? A mere 75!

So, don’t assume that your income needs stop when you retire. If your retirement is going to be the “golden years,” you will need money. If you set your sights too low, you can absolutely guarantee yourself a lifestyle of poverty in your old age.

Time Horizon

Time horizon is a critical factor in investment planning, but often not properly understood. Time horizon ends when you plan to liquidate an entire portfolio to meet a goal. For instance, if you are saving for a down payment on a house in two years, the time horizon left is two years. However, if you are investing for retirement, the time horizon is the rest of your life. Let me say that again: The time horizon for a retirement plan does not end the day you retire. The average married couple at age 60 will have at least one partner reach 93. By definition, that’s a very long-term time horizon.

One of the most inane ideas regularly foisted upon the American public is the idea that retirees should invest only for income, and that as investors grow older, they must become more conservative. Even The Wall Street Journal occasionally quotes some brain-dead financial planner reciting the formula that the percentage of bonds in a portfolio should equal the age of the investor. Hogwash!

Many financial planners who specialize in investing for retirees insist that their clients invest for both growth and income until their late 90s! Given the very long term that retirees can be expected to live, a planner who recommends a heavy percentage in “safe” fixed assets such as bonds, annuities, or CDs might later expect to be sued for malpractice since the investments and income failed to keep pace with inflation.

As we have previously observed, if you have a short time horizon, anything under five years, you have no business in the market. In the short term, risk to your nest egg is too high. So if you are two years away from building a new house, or your daughter is about to enter Harvard, your funds for those goals probably ought to be in CDs.

But market risk falls as the time horizon increases. It actually falls as the square root of the time horizon. That means that the difference between the best case/worst case expectations for a one-year time horizon is only one-third as large after 9 years, or one-fourth as large after 16 years. We have also seen that with very long time horizons, the worst case expectation in the stock market may be better than the best case with “safe” assets.

Dual Horizons

Retirees who anticipate living off their capital should consider that they have two time horizons. In the short run they will need income, and in the long run they will need a growth of capital and income. They should arrange their asset allocation accordingly.

Nothing is worse than having to sell assets at depressed prices to meet a need that we should have forecast and provided for. For retirees who need a steady income, in a very bad period, this could result in the portfolio self liquidating. Accordingly, I recommend that my retired clients set aside the equivalent of at least five years’ worth of income needs in very short-term bonds and money-market funds. The balance can be set aside to grow. For instance, if we are withdrawing 6% a year for our income needs, then we would have about 30% set aside for our needs in a five-year period.

In a bad year, we can liquidate the short-term bonds to provide for our income needs. In a good year, the stock-market funds can be reallocated back to bonds. The resulting 30/70 mix will suffer a small total return penalty, but because of the short-term bonds, the portfolio picks up a large increment of safety. In a bad market, the bonds allow us to “live off the fat of the land” while the stock market recovers.

Some fortunate retirees do not anticipate having to draw against their capital for extended periods of time. Perhaps they have a large fixed pension or other guaranteed income. In that case, there is no particular reason for them to invest more conservatively than they did before retirement, and no particular reason to load up on bonds. The market will neither know nor care what their age is, and the asset-allocation decision can be determined solely by their risk tolerance.

Risk: The Four-Letter Word

Risk tolerance is the final dimension of the goal setting process. We have discussed the unfortunate effects of excessive risk aversion. Retirees face a far greater risk of outliving their capital than losing it in a properly designed, equity-based, global asset-allocation plan. On the other hand, excessive risk at the portfolio level can lead to real and permanent losses. Where we take a risk, we want to achieve the highest rate of return per unit of risk. So, even if we have a high tolerance for risk, we shouldn’t just throw stuff against the wall to see if it sticks. The idea is to get rich, or at least achieve financial independence, not generate cheap thrills.

From my perspective, one of the biggest problems of risk is that when the market goes down, as it surely must do occasionally, clients will lose faith and bail out in a panic. Sometimes I suspect that when we speak of risk to the investing public, they filter out some of what we say. They may think that risk doesn’t apply to them, or that the professional’s role is to eliminate it in their portfolio, or that they will otherwise be immune.

So, when the inevitable market decline comes, investors feel betrayed, shocked, confused, and frightened. It shouldn’t happen to them! In this frame of mind, investors are primed to do the worst possible thing: sell and retreat to the “safety” of cash! All thoughts of long-term objectives vanish. The investor locks in his loss, and guarantees that he won’t be on board for the inevitable recovery.

Market risk means that sometimes your equities will go down. We can’t determine when that will happen. The market doesn’t care whether you just invested, or if you are above your starting capital, or how close you are to your goal. So, if you are in the market, get used to the idea. If you can’t get used to the idea, don’t go into the market. Better to have not been in the market at all then to panic and sell when the market dumps.

Decide in advance how much risk you are willing to tolerate. You may define it in many different terms. You could say to yourself that you want to be 95% certain (that’s two standard deviations) that you will never have a loss exceeding a given amount. Or you could say that you can accept a risk level about half way between the S&P 500 and short-term bonds. Or you could even say to yourself that you are willing to tolerate whatever risk is required to achieve a long-term result 3% better than the S&P 500.

Risk-Reward Relationship

However you define risk, remember that savers sleep well, while investors eat well. The relationship between risk and reward is almost a physical law. If the worst result you are willing to accept is a CD result, than that is also going to be your best possible result.

Now that we have decided where we want to go, we can begin to examine roads which will get us there. A clear statement of objectives, risk tolerance, and time horizon should be reduced to writing and will form the first portion of a policy statement for your investment strategy. The law requires that fiduciaries have and adhere to a written policy statement. But every plan should have a policy statement, and I strongly recommend that you put it in writing so that you can refer to it later. It will help keep you focused on achieving your goals, which will in turn help you to keep a clear head in times of stress. If you think that you can administer a long-term investment plan without occasional days of stress, either you are a very laid-back person or you haven’t been paying attention.

The next step in developing your strategy is to begin to formulate an asset-allocation plan which will satisfy the requirements we have just laid down. Stay tuned!