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Investing 102

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How to Define Your Own Wealth Plan with Goal-Based Investing

May 21, 2020

What is goal-based investing?

Do you feel uncertain about how you’ll reach your financial goals? It can be tough to follow the right action items, especially since COVID-19 has negatively impacted financial markets! Luckily, you can use goal-based investing strategies to methodically achieve your financial goals.

These methods will break down each goal into achievable steps that prompt forward action. Knowing your current financial status, risk tolerance, time horizon, the time value of money, and implementing SMART goals will help you obtain financial success.

Know where you stand

The first step to goal-based investing is assessing your current status. You can start with a high-level overview of your financial profile, which includes totaling your assets and liabilities. From there, you can categorize your assets by account type and other categories.

For example, you can classify your IRAs and 401(k)s into the retirement account section. It’d also be smart to separate your savings account from the retirement account section since those funds can be accessed immediately. Other asset classes include sections for tangible items like cars, real estate, or collectibles.

Now, categorize and organize your liabilities in the same manner. So, you could put long term liabilities like mortgage payments in one category. Then, you’d put short term liabilities like credit card debt and other short term loans in one area. When doing this, be sure to list out the balance and interest rate of each debt.

Using this granular strategy will let you pay off debt quicker using the pyramid payments method. The pyramid payments method encourages you to prioritize paying off debt with the highest interest rate quicker than the others. Implementing this strategy will help you save money that you’d pay in interest.

Establish your risk tolerance and time horizon

Knowing your risk tolerance and time horizons are key elements to goal-based investing. If you have a goal with a long term time horizon like retirement, then it’s more likely that you can tolerate riskier investments like stocks or ETFs. You might want to select more conservative investments like Certificates of Deposits (CDs) for a short term goal like saving for a home down payment in a few years.

Understanding the relationship between these two factors will help you create action items that’ll be in line with each unique goal. If you’re saving for retirement that’s decades away, you shouldn’t worry about short term volatility like market corrections. Stock indexes always increase over the long term and have always recovered after crashes like the 08 housing crisis. Knowing this will also prevent you from a common investing mistake: selling at the bottom.

Having a solid understanding of your risk tolerance and time horizons will let you select the right accounts based on your goals. For instance, you’d be better off investing for long term goals like retirement using 401(k)s IRAs due to their tax advantages. Conversely, you’d want to use short term, liquid accounts such as a high yield savings account or CDs for more immediate goals like saving for a car.

Understand the time value of money

Would you rather have $2,000,000 or a penny that doubles everyday for a month? You might want to select the $2,000,000, but this magic penny would result in $5,300,000 after just a month.

This simple principle demonstrates the power of compound interest and the time value of money. Many people erroneously believe that saving money is the best way to be financially secure. However, if you’re earning 2% every year with a CD, then you’re losing purchasing power to inflation. So, it’d be prudent to look for investments that can beat inflation long term when building a goal-based investing strategy.

Simple time value of money calculations are relatively straightforward. You can use a financial calculator, online calculator, or excel spreadsheet to calculate payments, interest rates, future, and present values.

Each of these tools uses common variables like:

N = Time periods, which could be years or months.
FV = Future value of your money after a certain rate of return over a specific timeframe.
PV = Present value of your funds.
I = Interest rate or rate of return.
PMT = Payment value. If you save $100 per month, $100 would be the PMT.

If you want to accumulate $10,000 in a CD paying 3% annual interest over 3 years, then you’d need to save approximately $153 per month! Understanding compound interest and the high-level time value of money calculations will quantify the actions you need to take to reach your goals!

Implement SMART goals

SMART goals tie in with the time value of money and compound interest. This guideline can be used for goals outside of finance as well.

This acronym stands for:

Successful goal-based investing revolves around this simple acronym. A good SMART financial goal would be to pay off $10,000 of student loans over 4 years. This goal fulfills SMART standards since it’s specific, measurable ($10,000 instead of a vague goal of paying off student debt), and timely (in 4 years). Before setting this goal, you must ensure that it’s realistic and achievable.

Some other factors to consider with this goal include the interest rate, your source(s) of income, and your cost of living. If you have a low salary and live in a high-cost area, then considering addressing those issues first. This will help you determine if your goal is achievable and realistic.

Per Henry Ford, “Nothing is particularly hard if you divide it into small jobs.”
This quote is very relevant to SMART goals since larger goals will be more achievable when you break them into smaller steps. For instance, a smaller goal could be to refinance your student debt, so that you save money long term.

From there, another logical step would be to calculate the monthly payment needed to pay off the debt. After that, you’d create a budget and include a section that represents your monthly payment. You could also use simple ways to cut expenses and increase income, which will ensure your monthly payment won’t break your budget.

Bottom Line

Life, especially finances, might seem uncertain due to the COVID-19 crisis. Industries like oil and transportation have been severely hit, which has hurt financial markets. Yet, you can use goal-based investing strategies like understanding your financial status, risk tolerances, time horizons, the time value of money and SMART goals to achieve financial abundance.

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