Every day, we are exposed to personal finance advice that can help us make better financial decisions. But this information is often scattered, redundant and difficult to navigate. President’s salaries, depreciation of office furniture, and office supplies are? The goal of this post is to offer a straightforward approach for developing a FINANCE strategy by providing the following eight simple steps.
1. Identify your goals
Before digging into the specifics of your financial strategy, it’s critical to clearly define what you are trying to accomplish. Are you hoping to reach financial independence (aka FIRE)? Or do you want to obtain the highest level of income? If so, you will need a different financial plan from someone who is more interested in retiring early.
2. Determine your risk tolerance
One of the most important considerations for developing a FINANCE strategy is understanding and accepting your own personal risk tolerance, or how much risk you are willing to take on with regard to investment returns. Remember that there will always be a finite amount of money available to invest, and that the source of income may change over time. If your risk tolerance is significantly higher than average, you may be able to take greater risks with your investments, but be aware that you are likely to suffer higher losses as well.
3. Start small
While having a large number of options is generally considered a good thing, it can also cause problems when an individual has very different attitudes towards risk. Some individuals fear the risk associated with investing in the stock market or real estate markets, based on past experiences or their own perceptions about the future. On the other hand, others believe that there is no risk associated with investing because they have a majority of their wealth in cash or some type of government-guaranteed savings program.
4. Where to put your money
Different categories of investment have different characteristics. For example, stocks and bonds have different risks and rewards. But you should also consider the specific portfolios within each category as well as the fees associated with each type of account. And don’t forget to factor in taxes when developing your strategy!
5. Frequency of checking
Frequency of checking is another risk management consideration. There are three possible extremes. The first is checking on the portfolio once a year or less often, which may be appropriate for some investors. The second is to check on the portfolio multiple times per day, which may be reasonable if you have a highly active trading strategy or you have significant capital at risk. The third is to check on the portfolio very frequently (e.g., every minute), which can lead to very large commissions being paid as well as increased emotions and stress levels when investing in stocks and other assets that can fluctuate greatly in value between checks.
6. Risk profile
Developing a risk profile is another important consideration. Take a hard look at your own personal situation (e.g., age, health, income level and other financial obligations) as well as your goals and risk preferences (more on this below). Many people who have a high level of risk tolerance are attracted to more aggressive investment vehicles such as options and other derivatives. But keep in mind that these products can also be very dangerous, particularly if you do not have a well-developed understanding of how they work or what is required to use them.
7. Exchange traded funds (ETFs)
A relatively new investment product, which is essentially a basket of stocks that mirrors a specific index, with an extremely low expense ratio. This type of account is also very tax efficient and can be used to build an individualized portfolio using multiple asset classes (e.g. stocks and bonds). ETFs offer investors many benefits, including lower costs and higher returns than traditional mutual funds. However, some ETFs charge large fees and expenses that can significantly reduce your long-term returns. Be sure you understand the costs associated with any ETFs before investing in them.
8. Withdrawal strategy
Once you’re ready to implement your FINANCE strategy, you should also consider how you will handle withdrawals in the future. You have several options, including a constant dollar withdrawal plan, which has the advantage of being guaranteed at a specified level (e.g., inflation adjusted), but it can also be difficult to follow through over time.
Another strategy is an annuity, which involves an insurance company agreeing to provide a fixed amount of income for a period of time. A third option is an immediate fixed annuity (aka deferred income annuity), which provides income that begins immediately or in some cases at some point in the future.
Finally, if you already have existing assets that can be invested, you may also consider taking advantage of index funds or similar types of investments. These have the potential to serve as a good starting point. But they are not necessarily the best choice for the long-term.
If you have an extensive understanding of risk management and advanced financial concepts, you may also want to consider using a Monte Carlo simulator or similar tool.