An investment in knowledge pays the best interest – Benjamin Franklin. Investing is putting one’s time, skills &/or money to work in anticipation of a worthwhile result. Investing in financial terms means putting our money to work to achieve an investment goal. A return on investment should mean a return on life. An example of this would be financial independence.
Step 1 - Start at The End & Work Back
Based on our current income today what level of income would we be comfortable with to become financially independent? Let's say after estimating our required level of annual income, we arrive at a figure of €75,000 per year. This is in today’s money. We will use this figure as part of the calculations to come.
If inflation averages 2% per year and our financial independence goal is in 25 years’ time, our future yearly income will need to be €123,045 to be able to afford the same goods and services in 25 years’ time. Now that we know our target income, we need to know the size of the fund that will support €123,045 of income per year.
The 4% rule is an industry rule of thumb that seeks to determine how much can be withdrawn from a fund while also maintaining the fund balance. If we use the yearly income target of €123,045 as our 4% annual income rate, we will need an investment fund of €3,076,125. We have our investment fund goal.
Step 2 – Savings Rate
If we truly know how much our lifestyle costs us and spend less than we earn, we will have a savings rate. Having a consistent savings rate is fundamental to building wealth. Four times zero is still zero. Compounding is often touted as the 8th wonder of the world. It needs foundations on which to build. The key ingredient is a savings rate and time. Let’s say we have a savings rate of €1,000 per month.
Step 3 – Time Horizon
How much time do we have to our investment goal? Ideally, the more time the better. Long periods of time dilute risk, based on historical investment returns. Our time horizon plays a significant role in determining the level of risk that we can take in order to achieve our investment goal.
Step 4 – Required Rate of Return
This is the yearly investment return we require to achieve our investment goal. Based on our investment goal of €3,076,125, a savings rate of €1,000 per month and a time horizon of 25 years, we require an average annual investment return of 14.65%.
Step 5 – Hurdles
Inflation has already been mentioned. Investment charges & tax (if applicable) have a major impact on the investment returns we receive into our pockets. If inflation is 2% and investment charges are 1.5%, we have a hurdle rate of 3.5%. If we add 3.5% to our required rate of return, we now need an average annual investment return of 18.15%.
Step 6 – Risk Tolerance
A risk tolerance questionnaire measures our relationship with investment risk. It is typically measured on a scale of 1 to 7. One being the lowest risk and seven being the highest risk. Our risk tolerance is our ability to endure temporary market declines while being able to sleep at night. Naturally we would all like to take zero risk and receive an average annual investment return of 18.15%. Unfortunately, the term no risk no reward rings true. If it were that easy everybody would be doing it. Therein lies the conundrum of risk tolerance questionnaires. We need 18.15% return but might score a 5 on the risk tolerance scale.
Step 7 – Historical Asset Class Return Ranges
An asset class is the grouping of financial assets
with similar characteristics together. The main asset classes are businesses
(stock/shares/equities), government and business debt (bonds/fixed income) and property (real estate).
Cash is an asset but not considered an asset class for investing in my
Average Annual Historical Investment Returns (35 Yrs)
Warning: Historical average annual return ranges are deceiving and do not relay the emotional capacity required to weather gut wrenching temporary market declines. The right investor behavior is critical to achieving investment returns.
These return ranges are not a guide to guaranteed returns into the future but are indications of what has been achieved in the past. If the future turns out to be similar to the past these are the returns that might be achieved.
Our required rate of return of 18.15% is not achievable based on the highest risk asset classes historical investment returns. The three other variables of investment goal, saving’s rate and time horizon will need to be adjusted. We can reduce our investment goal, increase our savings rate, work longer or a combination of all three.
Step 1 – Choosing an Investment Structure
In Ireland there are only two traditional investment structures available to most people. A pension or an investment. With a pension we get to keep more of the money we work hard to earn due to income tax relief. With an investment we will have forgone an immediate 20% or 40% return on our money because we will have paid income tax. Please see previous blog post on Pension or Investment here: https://money-mentor.ie/blog/pension-or-investment
Step 2 - Asset Allocation
Asset allocation is the proportion of businesses, debt & property we allocate our savings to. For example, our €1,000 per month savings may be allocated 60% businesses and 40% debt. Our asset allocation decision is one of the biggest single contributing factors to the potential investment returns we can achieve. Using the 60/40 split just mentioned, historically this type of investment portfolio provided an investment return of 6.4% before inflation, charges, and tax if applicable. If businesses are the whiskey, debt is the water in terms of reducing potential losses & returns.
Step 3 – Diversification
We can diversify across asset classes but also within asset classes. Geography, industry, size, and other factors add to diversification within businesses. Geography, duration, type, and quality add to diversification within debt. We diversify to mitigate risk as nobody knows for certain what the future holds.
Step 4 – Fund Selection
Having completed the previous steps we now choose the funds within our asset classes that marry all the previous steps together to help us achieve our investment goal. Our investment philosophy (Active &/or Passive) will play a large role in which funds we choose over others.
Step 5 – Rebalance as Necessary
Given investments rise and fall in value over time, it is likely our original asset allocation will change over time too. So, our 60% business and 40% debt investment portfolio might become 70% businesses and 30% debt. Rebalancing our portfolio periodically helps keep our risk and return thresholds in check.
Having said all that, the best thing anyone can do is to start saving. All big things start from small beginnings. Creating the right saving habits and periodically increasing it will set us on the right path to building wealth.
Link to Spotify podcast episode: https://open.spotify.com/episode/5oefF1ujcVCwnN5AQ6uQoH?si=83a8ff8d74f84b3b
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s2-e8-how-to-invest/id1539630506?i=1000541398975
For personal financial planning advice email email@example.com or call (01) 539 2670.