Monday, May 25, 2009

In control of your finances?

Returning to the topic of this blog; how to ensure progress in the important areas of life to ensure happiness and stress-free living, one of the things I deemed important as a student was money. This is, of course, still important to me. When we are talking personal finances, the issue of time comes up. You will have some long-term goals (become debt-free, have enough savings for retirement and so on) and som short-term goals (I really, really need a new iPod! Yeah!). How should you position yourself to ensure your goals don't slip? In order to analyze that, we need to become more down-to-earth and lay out a personal finance vision and put down a strategy for following up on that vision. I will not use the same tools for long-term goals as for short-term goals. Let us put down long-term goals first:
  • debt-free before retirement
  • to have $ 1 million in savings when I retire
to reach those goals, we obviously need to put money into paying down the mortgage (and other loans if there are any), and we need to put money aside. A common strategy is to put a fixed horizon on the mortgage and to follow the payment plan of the bank, to become debt-free. This strategy seems reasonable, let's keep it.

For putting money aside there are more things to choose from. We know that the expected returns from our investments are higher, the higher the risk we are willing to take. However, financial advisors tell me, not all risk is going to result in a higher expected outcome. Only risk that cannot be diversified away allows for a risk premium, says the finance guy. Ok...sounds reasonable (this is classic insight from finance and comes from the "capital asset pricing model").

We also know, from the control point of view, and from common sense, that we should be more afraid of losses as we get closer to target and the terminal time of our savings plan. Therefore, our money placements can be more risky when we are young, because we have time to recover if the market does something bad on the way (or we do something stupid). So, my strategy is to set a requirement on the expected return on investment for each decade, and then find an investment portfolio to suit that return on investment. Then, we need to compute how much to put aside each month and see if we can afford that. Possible investment return requirements:

Age 25 - 35: 15%
Age 35 - 45: 10%
Age 45 - 55: 8%
Age 55 - 65: 5&

We build up a portfolio for our current age bracket (25-35?). It will most likely consist of a lot of common stock (risky to not-so-risky), some money market funds (less risky) and some in a savings account in the bank. Mutual funds are great if you are not investing heaps of money, but beware of the conditions so you don't have to fund the fund managers when they do a crappy job.

So, when this has all been set up, how do you monitor performance and control it? Obviously, you should monitor annual returns. I would also set up a few other financial indicators, such as price-earnings ratio and earnings per share. Then, for example annually, I will adjust the profile such that it fits my desired risk. If I am earning more than expected, is this due to higher risk, or is it OK? If I am earning much less, I would reposition the portfolio (sell some stocks and buy some new ones). In any case, the most important thing is to add to the savings portfolio each month. Why? Compund interest. The sooner you get money into interest-bearing investments, the faster you earn more money. Say you have a dollar to invest. If you invest it today, what will it be worth in the future? We assume an interest rate of 15 % (quite risky!):

1 dollar invested at 15% interest is worth after
1 year 1.15
2 years 1.32
10 years 4.04
20 years 16
40 years 268

After 40 years your dollar is worth 268 dollars. If you had invested 1000 dollars, you'd have 268k available at retirement - compund interest is our best investment friend!

Next post: we'll look at short-term financial happiness

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