Define a financial goal

Investments begin with the goal set by the investor; horizon, that is, the investment period, and the acceptable level of risk. All further actions will depend on this.

Suppose you want to invest some amount, but you know that in five years you will definitely need it. In this case, it is better to choose a more conservative approach and bet on low-volatility instruments, for example, government bonds: with them there is less risk of losing money.

If the investor sets a long-term goal, you can make a portfolio with a predominance of stocks. An example of a long-term goal is to accumulate sufficient capital to retire in 10-20 years. I gave an example of calculating such a goal in an article about the formation of a pension portfolio.

Let’s say you want to save $ 360,000 (26,251,700 R) over 10 years to live on them in retirement. According to the 4% rule, this money is likely to be enough to withdraw $ 1,200 (R 87,500) monthly for at least 30 years. Let’s see what points need to be taken into account.

Inflation. It is important to adjust the target capital for the size of the expected inflation, that is, to understand how much we need to accumulate in order to have an amount equivalent to today’s $ 360,000. Money loses its purchasing power over time, and the rate of depreciation is different for each currency. In 10 years, $ 1200 will no longer be able to buy as many goods as you can afford today: over the past 10 years, dollar prices have increased 1.2 times. And $ 1200 from the beginning of 2012 is equivalent to $ 1427 today.

Let’s index our endowment capital – $ 360,000 – adjusted for the expected inflation in the next decade. I will take the value of 2.1% per annum, since this is the average inflation rate we have observed since 2010, when the economy was in the same stage of the business cycle as it is now. In addition, this inflation rate is predicted in the United States until 2030.

We index $ 360,000 using a compounding calculator for a period of 120 months with an interest rate change of 2.1% per annum. In total, our target capital in 10 years should be $ 444,000. Volatility is how the profitability of an asset changes. For example, stocks are more “capricious” and their quotes can change by several percentage points a day. And bonds do not experience such large swings in price, so they are considered a less risky asset. It is volatility that serves as a measure of risk in the stock market. If your portfolio is dominated by stocks, then your portfolio is more risky, but also potentially more profitable than a portfolio of bonds. Any investment strategy must take this point into account.

It all depends on the investor’s tolerance for risk: what portfolio drawdowns are acceptable for you in order not to experience stress and not commit impulsive actions? If a portfolio decline by 20-30% makes a person sell off assets in a panic, then he is unlikely to achieve his goal.

On the other hand, volatility and potential return are interrelated: the more risk an investor takes, the higher the expected return. Thus, at the planning stage, it is important to find a balance between the expected return and risk.

Other restrictions. Other factors can also affect the investment strategy: taxation of a particular asset, legal restrictions, for example, for civil servants and military personnel in the Russian Federation, as well as ethical considerations, for example, if the investor does not fundamentally want to invest in tobacco or cannabis companies.

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Cons of not having a financial plan. Without a plan, investors often build their portfolios from the bottom up, that is, they buy securities they like, without seeing how the portfolio works as a whole.

According to modern portfolio theory, overall return and risk are largely determined not by the indicators of individual assets, but by the degree of correlation, that is, the relationship between them. And it may turn out that even separate high-quality assets will not meet the needs of the investor.

For example, an investor will collect ten good commodity companies in his portfolio. The portfolio will turn out to be cyclical and with a focus on one or two industries. This will significantly increase the risk and potential drawdown in the final phases of the business cycle, when the economy experiences a slowdown or crisis, because the demand for raw materials will fall, the profits of commodity companies will also, and the assets in the investor’s portfolio are likely to lose value for some time. …

About what sectors exist and how they manifest themselves in different phases of the business cycle, I wrote in an article about the sectoral division of the economy.

If you don’t stick to a strategy, the investor will be more prone to making emotional decisions. Thus, many investors buy assets that have already risen in price and cut their positions during a fall in quotations, although this is the best time to buy. Such ineffective behavior, in particular, forms the so-called momentum factor in the market: an asset that has been growing in recent months, in the medium term, is most likely