Why Is Financial Planning Important?
Whether you have savings to invest or a retirement account, you may be asking the question, why is financial planning important? We all understand the importance of budgeting and saving for the expenses we have and the things we want to do, but what about increasing our assets and income through investing and financial planning? Is this a smart move? Do I need to hire a financial advisor? How do they charge me? What should I invest in, especially in today's ever-changing economy? These questions are all valid ones that we are going to attempt to address in this post.
What Should I Invest In?
First, you may be wondering what types of investments are out there for you. All investments belong to a certain asset class. The main asset classes are:
- Stocks (Equities) - When you own a stock, you own a part of the company. These are public shares in a company and typically the most risky asset class. With this risk comes the potential of having the greatest returns.
- Bonds (Fixed Income) -– When you own a bond, you are loaning money to a company or government. In return, they promise to pay you interest. This can create a dependable stream of income without as much potential for capital appreciation vs. stocks. The risk factor is considered to be much safer along with much less upside on return. One risk associated with bonds is interest rate risk.
- Real Estate – Your home belongs in this category. Beyond that, one of the most common types of property investments is through publicly traded real estate investment trusts (REITs). Several risks are associated with REITS such as liquidity risk and downturn in the real estate market.
- Commodities – These are raw materials and types of resources such as oil, gas, metals, and agricultural products. These are subject to the rise and fall of the economy and have significant risk as well.
- Cash – Cash usually has the lowest risk. The risk to cash is your government’s default risk. In today’s environment, cash pays little to no interest but it can be insured by the FDIC. Basically you are accepting a lower return value for the assurance that you won't lose your money altogether. Cash also has inflation risk.
What Stocks Should I Invest In?
Within the asset classes exist sub-asset classes. The sub-asset classes of equities or stocks can be defined by geographic market location and the size of the market.
- Large Cap Stocks – the largest publicly traded companies in the US (think of the S&P500)
- Medium Cap Stocks – the medium sized publicly traded companies in the US
- Small Cap Stocks – the smaller sized publicly traded companies in the US
- Developed International – these are the stocks of the developed international world. Think of Canada, the UK, Germany, Switzerland, etc.
- Emerging Markets – these are the international stocks of countries like China, India, Brazil, and Russia, plus many smaller emerging market countries.
There are sub-asset classes for fixed income that are relevant as well, but for the sake of brevity we will not discuss them here.
So, which should you invest in and which should you avoid?
That’s where asset allocation comes into play.
Asset Allocation and Using a Financial Advisor
*Asset allocation is an investment strategy that is designed to balance the investor's risk and return attributes of an asset class (or sub-class) with the investor’s risk tolerance, time horizon, and financial goals. This is done through the diversification of asset classes. All this means is that you don’t want to put all your eggs in one basket. What if you invested everything in Russian stocks and then Russia’s economy suddenly imploded? Then, your portfolio would implode, too. So, we want to make sure you have some investments allocated here, and some invested there, according the appropriate risk and reward profile. Using a financial advisor to design this portfolio can take the guesswork out of it for you.
Can You Beat the Market and the Advantages of Having a Financial Plan
You’ve probably heard the statistic that only 10% of investors beat the market. Whether true or not, it’s common knowledge that the vast majority of investors, managers, and mutual funds cannot consistently beat the market. We’ve all heard the noisy pundits on TV and radio. They are not much help when it comes to predicting what the market is going to do. Usually, they are just plain wrong. So, how do we play the game to win if we don’t know what the market is going to do? First, we admit that we don’t know what the markets will do and that no one can. You should think twice about anyone who tells you differently. Knowing that we cannot predict the market gives us the power to plan for a range of outcomes. We can plan for up-markets, down-markets and sideways-markets, and invest accordingly.
So, we know what we can’t control: the markets. So, what can we control? Many things. We can control your asset allocation and therefore your investments. We can control your costs by choosing low-cost funds. We can control the tax-efficiency of your overall portfolio by making sure you use the tax code to your advantage: think tax-loss harvesting and capital gains management. We can place investments in the type of account that is taxed most advantageously for it: think Roth’s for growth, Traditional IRAs for REITs, and taxable accounts for tax-free investments like Munis. We can control in retirement how you withdraw from those accounts. We can control how you manage risk, such as through life insurance. We can manage risk by having contingency plans for down markets, too. We can control when you file for social security. So, by knowing what we can and cannot control, we can better optimize our portfolios and our financial life.
Today’s Fee-Based Model (Advisory Model) vs. the Model of the Past
Most advisors today use a fee-based model (sometimes called the advisory model). The model that was more popular in the past was based on commissions. The difference is how a client is charged. The commission-based model charges the client every time there is a transaction, such as the buying or selling of stock. The fee-based model uses a fixed percentage fee based on the assets under management, regardless of how many transactions there are. The fee-based model commonly includes not only investment advice, but also comprehensive financial planning. Typically, there is less conflict of interest with the fee-based model because as the client’s account value goes up, the advisor makes more money, and as the account goes down, the advisor makes less. Therefore, the interests of the client and advisor are more naturally aligned than with the commission model. With the commission model, the advisor makes money when something is bought or sold.
*Asset allocation programs and diversification do not assure a profit or protect against loss in declining markets. No program can guarantee that any objective or goal will be achieved.