As most investment books and financial advisors would suggest, managing your personal assets should start as early as possible, preferably the moment you receive your first income. It’s never too early to start, and never too late either. Regardless of your age or financial situation, having a basic investment strategy is still necessary. A good place to start would be to ask yourself the following questions:
1. Which Life Stage are You Currently at?
People have different priorities and obligations at different life stages. Generally speaking, younger people invest for growth, older people invest for income.
Those in their 20s and 30s are encouraged to take on as much risk as they can tolerate to maximize potential return, and here is why: Firstly, people in their 20s and 30s usually have fewer financial burdens, especially if they haven’t gotten married or had kids, and if their parents are healthy and working.
Secondly, people in their 20s and 30s usually don’t worry about major health care expenses. They can set aside a relatively small portion of their income into an emergency fund, and save up the rest of their earnings for investment.
Thirdly, people in their 20s and 30s have the longest time horizon, which means that time is their greatest asset. The earlier they invest, even if it’s depositing into an Individual Retirement Account (IRA), the more benefit they will receive due to compounding interest.
40 to 50 year olds are recommended to transfer a portion of their wealth into less risky investments. For example, if their stock to bond ratio used to be 90% to 10%, they can now consider adjusting it to 70% to 30%. However, at this stage they may still need to invest primarily for growth.
Here is why: Firstly, people in their 40s and 50s still have time to make changes in their investment portfolios. They still have at least 10 to 20 years before actually retiring, and that is too much to give up.
Secondly, people in their 40s and 50s are generally at the peak of their earning powers, which means they now have the capital that was lacking in their youths.
Thirdly, people in their 40s and 50s are probably also at the peak of their expenditure needs. For many people in this life stage, they need to buy a house, put children through college, and look after their retired parents. They may need to set aside a mortgage account, a college tuition account for their children, as well as an emergency fund for unforeseen expenses.
Are You Retirement Ready?
60 to 70 year olds are usually approaching retirement or have already retired. A well known rule is subtract your age from 100 and get the percentage of your wealth that should be invested in stocks or other risky assets, but the new rule uses 120 instead of 100 due to longer life expectancy.
In any case, retirees are generally recommended to keep the majority (but not all) of their money into income generating investments, and here is why: Firstly, people in their 60s and 70s usually have fewer financial liabilities. At this stage, they may need to spend less for social purposes, and if everything goes well, their children may have grown up and moved out.
Secondly, people in their 60s and 70s will likely face higher health care expenses, which statistically rises faster than inflation. Without a regular job to provide income, retirees need to rely on investment gains.
Thirdly, people in their 60s and 70s have less time to recover from investment mistakes or financial crisis. Retirees need to know that they can still get by even if something disastrous happens.
2. How Comfortable are You with Risk?
Risk tolerance is not necessarily correlated with age, although people tend to shift towards more conservative investment strategies as they age. Younger people can afford to take on more risks, because they have more time to correct their mistakes. Therefore it is not exactly age that determines risk profile, but the time horizon. The longer your investment time horizon, the more risk you can potentially take.
Investopedia categorizes investments into three risk baskets, lined up in the shape of a pyramid.
At the top of the pyramid are the most risky investments, including options, futures and collectibles. In the middle are the less risky investments, including real estate, equity mutual funds, large/small cap stocks, and high income bonds/debt. At the base of the pyramid are the least risky investments, including government bonds/debt, money market/bank accounts, CDs, Notes, Bills, and of course Cash.
Risk is a combination of market liquidity and price volatility.
Higher risk is usually rewarded with higher potential returns. Long run equity returns can be derived from the sum of dividend yield and the real dividend growth rate, based on the Gordon Growth Model. Real equity market returns have been approximately 6% annually over time, not accounting for trading costs, investment management fees and taxes. Studies such as 2002 Dimson, 2002 Fama and French and 2003 Ibbotson and Chen have found an expected equity-bond risk premium near 4% in the US, averaged over long histories. However, it’s also important to keep in mind that there have been many examples of negative 20-year equity premium in other countries.
With regards to the relationship between risk tolerance and investment strategy, here is what Charlie Munger thinks:
“Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilize a very conservative patterns of investment and saving all your life. So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.”
3. What is Your Investment Goal?
The biggest concern for younger people is not saving enough. Two pieces of advice offered by Charlie Munger are particularly suitable to the younger crowd.
First of all, cash is king. Having sufficient cash on hand is necessary when good investment opportunities come around.
Secondly, spend less than you make. If you put your savings into a tax-deferred account, it will begin to amount to something over time. Check out our previous blog post on finding the investment strategy that’s most suitable for you.
Retirement planning is different from what it used to be, according to Robert Carlson, author of “The New Rules of Retirement”. It’s not uncommon for people approaching retirement age to realize that they are not financially ready yet. In 2015, two thirds of Americans between 45 and 60 said they would delay retirement.
According to an MIT study, nearly half of all Americans die with financial assets of less than $10,000. As life expectancy grows, people can expect to spend more than 30 years in retirement, during which they still need to generate income to support themselves.
Retirement investment advice used to be: allocate more of your portfolio into safe, income producing investments as you age. More recently, retirees were told to invest like everyone else, using diversified portfolios developed with historic returns and computer programs. Many people make the mistake of underestimating the amount of time that they will be spending retired. Check out our guest post here on why people may not have a successful retirement.
It’s always good to remember that reaching retirement is not the ultimate goal. Being able to live comfortably in retirement is.
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