Step 3 – What’s the price of your dreams?
It’s time to make the game winnable. This goes back to the beginning of the article. What are your goals? What are your dreams? And how much will they cost? Like most of us, you probably don’t have a clue how much you really need to meet your needs. Here are the 5 levels of financial prosperity.
Financially secure – How much you need to cover the basics (food, shelter, basic transportation)
– Basic costs for average American – $39,000
Financial vitality – Above + How much you need for some of the perks (memberships, hobbies, entertainment)
Financially independent – Above + How much you need for vacations, etc.
Financial freedom – Above + 2 or 3 big wish list items
Absolute financial freedom – The money to do whatever you desire
Pick three of the financial milestones above and write down what you would need (in dollars) to meet these goals. You need to have an idea in mind of how much you actually need in order to attain these levels of financial prosperity. Just having some arbitrary number floating around in your head isn’t going to do you any good. Most people have no idea how much money they need to reach these levels. Putting it to paper gets it from some fantasy in your mind to something more concrete. After doing this exercise you will know how much you need to be financially secure, independent, etc.
As a side note, you want to set up an emergency fund first. This is a huge stress reliever. Consider having about 3-6 months of pay in a savings account somewhere that is easily accessible.
Quick recap – How can we best invest? First find ways to save more and earn more. Then, invest that money so it is growing (compounding). Next, we need to focus on reducing taxes and fees. It’s not what you earn, it’s what you keep. Look for tax efficient strategies and accounts. Consider tax deferred accounts, compound tax free, and future tax free. Also consider a Roth IRA. Make sure to hold it for a year for lower long term capital gains rate.
Step 4 – Asset allocation
This is the most important investment decision of your life. This step is all about determining where to put you money and how much. There are many ways to allocate. There are two categories, secure buckets and risky buckets.
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First, let’s cover the safe options
1 – Cash/cash equivalents – bank, etc.
2 – Bonds – buy a bond and they return money with interest over a certain time (many are rated). It’s best to buy low cost low fee bond index funds since they spread out the risk.
3 – CD – This is a loan to a bank and they give the money back with interest (very low return).
4 – A house – this is an investment, but houses do not go up unless there is a bubble (and we all know what happens to bubbles).
5 – Pension – if you’re lucky enough to have one.
6 – Annuities – these are insurance products that can give income for life. It can be like a pension if set up correctly (more on annuities later).
7 – Life insurance
8 – Structured notes (not covered by FDIC) – these can be risky or secure, but it’s best to discuss these with a fiduciary.
Now, lets’ cover the risky options. Just remember, you could lose it all with these investments.
1 – Equities – aka stocks, mutual funds, ETFs (like a mutual fund but you can trade them – short term trading).
2 – High yield bonds – junk bonds, bonds with low safety ratings.
3 – Real estate (rent, flip, commercial, apartment, REIT (real estate trusts))
4 – Commodities (gold, silver, coffee, cotton, etc.)
5 – Currency trading (Yen, etc.)
6 – Collectibles – art, wine, etc
7 – Structured notes (different types – some have 100% principle protection, some have less)
How much risk are you willing to take? It depends on your age a lot of the time. Younger investors can usually take more risk. Taking these kinds of risks close to retirement is, well, risky! It’s a personal call really, but consider your stage in life, the risk you can stomach, and liquidity.
One example of asset allocation is as follows:
David Swenson (Chief Investment Officer at Yale University and manages $23.9 billion in assets) has 30% in bonds (15% long term US treasuries and 15% in TIPS (treasury insured protected securities)) and 70% in risks (20% real estate investment trusts, 10% developing nations/emerging markets, 20% broad domestic 500 index, and 20% international stocks).
Don’t be afraid to have some fun investing, but pick stocks and play around with only 5% or less of your portfolio.
In order to help you stay on track, set up a dream bucket. These are strategic splurges. This is the equivalent of a cheat day when you are on a diet. You’re sticking to the plan 90% of the time and having a little fun to keep your sanity once in a while. You want to enjoy the money you are making. You don’t want to be someone who just tracks numbers on a computer screen until you croak, right? So, have some short, mid, and long term dream buckets. Make a list and decide why it is important to you.
A couple side notes: winter is the time to buy. When things look grim, this is when many people make their fortunes. When the stocks are falling, don’t sell out and lock in your losses (like what happened to many in 2008). Ride it out! Historically the stock market will always go up over the long run.
With your portfolio, it is important to diversify over classes, markets, and time.
Consider dollar cost averaging. This essentially spreads your money evenly over your assets periodically (to whatever percentage you have it set to). The good thing about this is that it takes your emotions out of investing. Re-balance once per year. Also consider using tax loss harvesting to lower taxes when you sell.