June 10, 2009 in Investing

Many people go about investing in sporadic fashion, without considering their goals, time horizon or risk tolerance. They put together a thousand bucks, call a broker and ask for a stock recommendation. Or they sign up for 401(k) plans — a good thing — but plan to tap them early without realizing they’ll have to pay stiff penalties plus taxes to do so. Still others dutifully open accounts and invest without truly examining why. And dreams? For many, dreams are for those rare moments of reverie and don’t even enter the process.

Figure out your dreams, goals

Instead of following a financial formula and then seeing if it makes sense to pursue your dreams, you should work from the other direction, says life-planning pioneer George Kinder, author of “Seven Stages of Money Maturity” and founder of the Kinder Institute of Life Planning. First determine your dreams, then use financial planning to help you get there.

Use this work sheet to help you determine your goals.

Fine-tuning your investments:
  1. Figure out your dreams, goals
  2. Balance multiple objectives
  3. Consider your time line
  4. Invest for your time horizon
  5. Determine your risk tolerance

It’s important to explore even those desires you wouldn’t normally consider discussing with a financial planner. Whether you want to spend more time with your family, play the guitar like Eric Clapton or learn to fly a plane, you’ll need to figure out how to free up the resources — the financial and time components. After all, time is money.

“Write down five to 10 financial objectives,” says John Grable, professor in personal finance planning at Kansas State University. “It’s unlikely you’ll be able to fund them all unless you’re very rich. What you’ve got to do is determine what’s important to you and then prioritize meeting the goals.”

Balance multiple objectives

It’s not all about the pie in the sky.

“Out of your dreams, do some realistic goal setting,” recommends Richard Salmen, Certified Financial Planner and national president of the Financial Planning Association. “If your goal is to save up for a down payment on a $240,000 house, you’ll need to save $800 per month for the next five years in order to reach it,” he says. “Start with the big picture at the end and work backwards to achieve it.”

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It may be necessary to adjust your goals. Salmen tells the story of one couple who dreamed of buying a ranch in Montana, but after looking at prices and income realized they wouldn’t be young enough to enjoy their dream by the time they could afford it. They settled on a smaller farm outside of Kansas City instead.

“Now they have a baby with Down syndrome and they had to readjust again,” he says. “‘Life happens as you’re planning it,’ is our favorite saying around here. Planning is a process, not a product.”

Use this calculator to run the numbers and see how much you need to invest or save to achieve your goals.

Consider your time line

Another piece of the puzzle is your time horizon. Some goals come with a set time frame, such as education.

“Once you have a baby you know you have 18 years until the first year of college hits,” says Shashin Shah, a Chartered Financial Analyst, Certified Financial Planner and president of SGS Wealth Management in Dallas.

Other goals don’t have an expiration date, but can depend instead on your financial wherewithal: when to retire, for example, or moving into a bigger house.

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“If someone starts with nothing at 35 and wants to retire at 50, they’ll either need to achieve a 20 percent return on their investments, work longer or back off their goal savings amount,” he says. “They’ll need to find out what they are willing to do to achieve their goals.”

You don’t want investments to get eaten up by taxes, but before funneling every extra penny into tax-deferred investments such as a 401(k) plan or IRA, consider carefully if you might need the money for some other purpose before retirement. Otherwise, you’ll feel the bite of penalties.

“This is a little known fact for mainstream America,” says John Pallaria, adjunct professor in the Certified Financial Planner program at Boston University, “but if they are under 59½ and tap a 401(k) or its equivalent to pay for education, they’ll be hit with taxes and a 10 percent penalty on the amount of withdrawal.”

Dipping into IRAs early is admissible in some circumstances, including education: “They can actually tap IRA products before 59½ and pay taxes but no penalty when using the funds for education,” he says.

Invest for your time horizon

Determine your investment horizon to put your money in appropriate investments.

Short-term: For goals with a term of less than three years, you generally don’t invest in the traditional sense. You save for them. For example, if you’re saving for a down payment on a house, you’ll want to put your money in a safe place that will be available when you’re ready, without loss of principal. Consider six- or 12-month CDs, though you’ll pay a penalty to access your money early; FDIC-insured high-interest-earning money market or savings accounts; low-cost money market mutual funds; or stable value funds. Find the best rates for these types of deposits on Bankrate’s rate tables.

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Intermediate-term: These goals are five to 10 years away. The key here is diversification. Look at keeping a small portion in higher-yielding money market accounts and CDs, and include Treasury securities, short-term to intermediate-term bonds or bond funds. If your timeline extends beyond five years, some equity exposure may be appropriate — perhaps an index fund, which tends to be more tax-efficient than other funds, if this money is in a taxable account. Consider allocating a small portion to an international stock fund if you want to take on a little more risk.

Long-term: Depending on your risk tolerance, most people should be able to handle a bit more volatility in their portfolio; the alternative is to risk falling short of your goal. For goals beyond 10 years, a 70 percent allocation to equities might be appropriate because you’ll need growth. Conservative investors nearing the 10-year mark may want to invest in a mixed stock and bond portfolio.

See examples of asset allocation charts in Bankrate’s story, “Building a portfolio.”

Determine your risk tolerance

Try to keep out of investments that will keep you awake at night worrying about losses but expose yourself to enough risk so that your investments have the chance to grow.

“One thing people need to do is have a heart-to-heart with themselves,” says John Pallaria, adjunct professor in the Certified Financial Planner program at Boston University. “How would they feel mentally if the $5,000 they invested Friday was only worth $4,200 on Monday? If they’re uncomfortable with that, that’s a red flag that they should consider the investment carefully and make sure it’s a good fit.”

Before you let yourself get too frightened off, be realistic. You have to be willing to assume risk if you want higher returns.

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“Sometimes I hear people say, ‘I don’t want any volatility but I want to earn 8 percent.’ It’s impossible,” Pallaria says.

Whether you’re a DIY investor or are ready to run straight to the nearest financial adviser for help, it’s important to assess your risk tolerance first. Even if you are a risk-taker in other areas of life, that same willingness to handle risk doesn’t necessarily carry over to your financial life.

John Grable, professor in personal finance planning at Kansas State University cautions: “Don’t just walk in thinking that the financial adviser will figure it out for you. Financial advisers come with different risk styles themselves.” If you have the capacity to handle riskier investments and the stomach for it, a conservative adviser wouldn’t be a good fit.

George Kinder, author of “Seven Stages of Money Maturity” and founder of the Kinder Institute of Life Planning says, “The thing with risk tolerance is, if you don’t know what you’re aiming for, it’s very difficult to know how much risk you’re willing to take. If you’re aiming for the wrong thing, it’s also difficult. If you’re passionate about your aim, the amount of risk you’re willing to take becomes very clear.”

Still not sure how much you can stomach? Take this quiz to determine your risk tolerance.

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