The 3 dimensions of investment planning

In the financial world, investments make the world go round. There are numerous articles, strategies, professionals and algorithms working day and night to fight each other for that extra 1% – call it return, risk or fees.

For an average investor or someone just interested in growing his/her wealth to have a good financial life, it is a huge distraction and confusing to say the least.

With the various investment options and opinions, whatever you do seems little and a wrong decision somehow.

Instead of ranting, let me take a few examples:

  1. I had been investing in Index Funds for some time now. Then as my portfolio grew, some well known investment firms started calling me to pitch how they have beaten the market over last 25 years.
  2. The investment choices available today are myriad – bonds, stocks, mutual funds, real estate, gold, commodities and exotic art. Whatever you choose for your portfolio, you will be left wondering if you are doing it right and if you are missing out on the next wave.
  3. The temporary market crash due to Covid-19 and the subsequent surge in Gold for some time now can make you wonder if you should have rushed to buy a ton of Gold.
  4. Each investment then has different tax treatment and tax shelter on how you hold them. Before you reap the benefits, the taxman comes calling for his share.

As an average DIY investor, I see there are 4 dimensions to the problem.

  1. Goals and time horizon
  2. Choice of investment
  3. What you keep (after Tax and Fees)
  4. Making it a habit and automate it

If you view the above aspects as a 4 dimension space, then really it is all about allocating correctly across all the axes.

If you look closely, the dimension 1 and 4 can be squeezed to one called time. The 4th dimension is just an execution process.

So let us define the 3-D space now in a simpler manner.

  1. Time according to life’s goals
  2. Return on Investment and the choices
  3. Cost of investment – taxes and fees

The First D – Time and Goals

Time is one of most important dimension of the investment space.

They say – It is not market timing but time in the market. 

Any investment that you consider has to be first mapped to this dimension.

Let’s say if you cannot predict the exact no. of years, you can still divide the axis into 3 sections. Let us look at some typical life goals that we can map to these 3 sections.

Short Term Requirements (1- 3 years)

  • Emergency Fund
  • Short term goals – buying a house, car etc.
  • Short term obligations – paying taxes, insurance, credit card

Medium Term Requirements (3-10 years)

  • Education Fund for children
  • Debt payoff plan – car loan, personal loan
  • Building savings for buying more assets

Long Term (10-20 years and beyond)

  • Retirement Fund
  • Mortgage payoff and debt-free plan
  • Wealth building and giving

Simple? So far so good.

The Second D – Return and Type

This is where most of the confusion is. As the choices are unlimited, most people ignore the risk-return tradeoff. In the chase for returns, they forget to look for the risk and burn their fingers in wrong kind of investments.

It is always better to set your expectations first, and then map the type of investments.

When you start with the first dimension Time and Goals, it is easier to set the correct return expectations and hence the risk-return tradeoff.

Let us now place our expectation of return on the second axis for each section of the Time axis.

Short Term

  • Emergency Fund
    • It does not matter. This is a fund not for growing your wealth but only for emergencies.
    • Return expectation – 0-2%
  • Short Term goals
    • Depending on what the goal is, the primary objective is still capital safety.
    • Return expectation – 0-2%
  • Short Term Obligations
    • This is for tax payment, annual insurance payments, credit card payment etc.
    • Again we are just saving money rather than investing.
    • Return expectation – 0-2%

Types of investment:

  • Normal Savings account
  • High Yield Online Savings account
  • Money market account

You do not need more than 2-3 savings account mapped to the short term goals. The funds should be completely liquid and accessible in a day or two.

Medium Term

Here we are talking about 3-10 years time horizon.

Since the goals in this bucket may be slightly ambitious and we want to fight the monster called inflation, the return expectation should be slightly higher than inflation but with considerable less risk.

This is also easy to determine:

Types of investment:

This is where we start searching for good mutual funds. For this time horizon and return expectations, the following may fit one’s portfolio

  • Balanced Index Funds which have majority in bonds (60% or more)
  • A good bond fund with duration of 5-7 years.
  • Balanced Equity Funds (aggressive option with 60-70% equity)

Again, here 2-3 funds with returns just beating inflation should be good enough. As you will need the money in less than 10 years, it is better to focus on less risk. 

Long Term

This may be (depending on your age) 10 to 20 years or more.

For such a long term, it is not only inflation that we want to surpass but also several other factors that come into play.

  • Building passive income sources
  • Diversification to contain risk

All of the above can set our return expectations differently.

For example, the retirement draw number can set the expectation in the following manner.

  1. For someone who does not yet have a good corpus, you need to know how much more to save to reach your retirement draw number. Experiment with realistic numbers for return and how much you can save.
  2. If you have already accumulated a significant corpus, then your return expectations may be lower. Instead of going for highest return-risk, you can calculate what return will it take (assuming further regular investments till you work) to reach your passive income goals, or retirement draw number.

There are 3 avenues by which you can reach your goals.

  • Appreciation via Stock/Fund investments – The S&P 500 has returned 9% annually
  • Dividends from stocks and funds – 3-4%
  • Real estate investments can return 7-10% as passive income from rents, REITs etc.

Types of investment:

Here we need aggressive investments (as per return expectations set above) if you have more than 10-15 years of horizon.

  • Low cost S&P 500 like Index Funds and ETFs
  • A High Yield Dividend ETF or Dividend stocks of stable companies
  • REITs or direct rentals

The time horizon itself reduces risk for these aggressive investments.

However you can diversify further in each of the 3 types by going global.

  • Low cost International and Emerging Markets Index Fund and ETF
  • Global REITs

The Third D – Taxes and Fees

Now that we have placed the whole investment picture in two dimension (Time and Return) , we have to make sure that the 3rd dimension does not go too high.

Ideally we would like this dimension to be ZERO for all and remain flat in the 2-D plane. But in real world, the free lunch is a myth and the flat surface will be pulled upwards (or downwards from our perspective) in 3-d by taxes and fees.

Dimensions

If we look at it from the 2-D plane again (Time and Return), there will be different rates of taxes and fees, and our goal should be to minimize them.

This is where the allocation of investments into different types of accounts apply.

  • Short Term
    • There is not much return expectation anyway, so the taxes will be negligible.
    • The fees are important here and should be close to 0.0 in savings account, money market funds etc.
    • The type of investments in this segment will not qualify for long term capital gains, except for short term obligations that are just beyond one year. However rarely do safe investments get special tax treatment in such a short duration.
  • Medium Term
    • In this category, both fees and taxes become important.
    • Due to the 5-7 years horizon, most equity gains will be long term capital gains (20% or less) and get preferential tax treatment.
    • Further to shield from taxes, one can use Roth IRA, 529 plans according to the goals.
  • Long Term
    • As in the medium term, both taxes and fees are important.
    • Being long term, fees paid every year can eat away 20-25% of the corpus in the long term.
    • There are several options in US like 401k, Roth 401k, IRAs, HSA to defer or minimize taxes for the long term. In India, the NPS, PPF, EPF are all good options.
    • In real estate, the depreciation and 1031 exchange are important tax optimization tools.

For taxation matters, it is mandatory to consult an expert professional in the domain.

However for any of the above, we should be choosing only investments that matches our moderate return expectations with very low fees, definitely much less than 1%.

This can be achieved via simple Index Funds and ETFs.

In this graph, the taxes and fees matter (hurt) most in the short term and long term (due to deferred treatment and not exemption).

Dimensions

The Fourth D – Automate and Track

Automate everything and let it run like a bullet train.

If you need help on how to set up your finances, here is a link.

How to manage your cash flow

train

 

1 Comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s