As I help my friends and family with financial knowledge, I have seen several people are good at saving money. They have loads of cash stored in checking and savings account, and are looking for ways to get started with investing.
Few of them also start investing on their own or look for completely different reasons for investing.
There are usually neither goals or asset allocation defined, nor any analysis of the investment products that may suit the person.
Instead the process relies on finding the most popular investment, which often results in buying the hottest stock in the market or the top performing mutual fund for this year.
Another reason for starting to invest is to save tax. Saving tax is a good goal, but if the investment purpose is only to save tax, then the person does not know how else to invest beyond what is allowed as limits for various tax-free and tax-deferred instruments. It is also very strange that most financial gurus advise to max out tax accounts without any consideration to the person’s other liquidity requirements.
Yet another confusion about investment planning is people start looking for a professional investment advisor, without doing their own homework on what is important to them and their financial future.
A professional investment advisor (even if he/she is a fiduciary) mostly takes care of investing a corpus, according to the age of the person and to satisfy long term goals like retirement or wealth maximization.
This is however not the right way to start, if a person is serious about building a solid financial and investment landscape. I too started the wrong way, and called one of the wealth management advisors of my bank. The bank executive was obviously more interested in making money for the bank, than in my investment suitability. I was sold the highest cost insurance product in the name of investment and when I cancelled the policy after few years, I had already lost money to fees, commissions and surrender charges.
So after talking to several people and finding the common issues of getting started, here are the 4 things that should be in-built in every investment plan. This is how I look at my own financial plan.
Defense is the first level of offense. That is why, in sports that I am familiar with, there is always a defense lineup first. In soccer and hockey, it is the goalkeeper and defenders. In cricket, you have the wicketkeeper and the fielders. In chess, a professional player always thinks of defending the most important pieces and then thinks of attack. Here is an interesting article.
How to Defend in Chess — 7 Most Important Defense Principles
Like these examples from sports, the first line of defense in personal finance or investment is the Emergency Fund. This is the Sleep-in-Peace fund, Fire-your-boss fund or Contingency fund, which typically stores 3-6 months of expenses for a person, including his or her debt expenses like mortgage, car payment etc.
I normally follow a second line of defense which is a Sustenance Fund. This fund is a source of 1-2 months of expenses and is used for those months when the budget goes haywire and a person ends up overspending. Now to avoid credit card interest or overdraft fees for checking account, there has to be a buffer between spending and accessing the emergency fund. Emergency Fund should not be touched for overspending but only for real emergencies like medical, car or house appliance breakdown, job loss etc.
Now security should not only be a short term buffer, but also longer term which involves major life happenings. If a working person in the household dies, the rest of the family should not come to the streets or go through financial hardship. This is what Term Insurance is all about. I will not go into details since Term Insurance is a very simple to understand product and I am not an insurance professional.
Thus a person looking to invest should do the following 3 things first:
- Setup a savings account in an online bank and deposit 3-6 months of expenses as Emergency Fund.
- In a relatively easier to access account, save up 1-2 months of Sustenance Fund.
- Call an insurance professional, assess and buy Term Insurance for the right amount.
- Owning a home can also be part of the Security bucket.
This is where the most exciting part comes, the aggression and the offense. The investor feels like the smartest person on earth and goes after maximum rewards, forgetting that rewards come with symmetric amount of risk. Direct stocks, options, futures, leveraged investing, real estate, crypto all have their own set of risks and need to be taken into account when thinking of growth and rewards.
Here also a tiered approach helps to build a growth machine. I am not an investment professional but this is what I follow for my own Growth Bucket.
- Low cost broad based index funds – S&P 500, Total International Market, Total Bond Market
- Low cost theme based index funds or ETFs – Emerging Markets, Dividend Yield, R.E.I.T, Technology
Most people can just stop at the above two or even the first one. There is no need to invest in more esoteric products than broad based index funds.
Once the above two are tested and a base built for growth, there could be a supplemental part of the portfolio. Below is my supplemental portfolio but I restrict the amount in each. Across each, I have given the names of services/stocks I use but it is neither a recommendation nor do I have any affiliate relationship with them. Each of the categories has competitor products, so do your due diligence to select the best that suits you.
- Direct stocks for dividends or growth – a brokerage account like Robinhood
- Private Real Estate Investment Trusts – Fundrise
- Gold or precious metals – Ownx, Money Metals
- Cryptocurrency – Coinbase
- Turnkey real estate for rentals
The central idea is that one should not get creative in this segment, but go with fully understanding the risk of each asset class, and then invest in a staggered way (start small and regular in smaller increments).
Income does not mean here from the job or business that one is actively involved in.
Here we will talk about income that an investment or an asset can produce. This is an income that can be generated every month or year without doing any active work, hence called passive income.
Typical passive income sources are:
- Interests from savings account and fixed deposits (also called certificate of deposit)
- Dividends from stocks, mutual funds, REITs and ETFs.
- Cash flow rental property (with property management to avoid the active work)
- Income from annuity or likewise products (insurance products)
- Royalties from pieces of work like a book, art, music.
- Online business like a course, youtube etc.
All of the above though requires work in selecting, setting up or buying the right asset. However once acquired, stabilized and started, there is very minimal work to maintain the income.
As a person gets later in life, the importance of passive income becomes paramount. Growth investments are good, but the growth is only on paper till the instrument is sold off. Once sold, the problem is back to square-one, where does one re-invest the proceeds after taxes etc.?
So setting up some assets for income is an essential part of investment planning. Thus a portion of the initial corpus has to be set aside to acquire income generating assets.
A simple starter form of this portfolio could be:
- REITs or a broad REIT based index fund or ETF
- Dividend Stocks that are picked after research
Warren Buffet’s two rules of managing money.
- Rule no. 1 – Don’t lost money
- Rule no. 2 – Don’t forget Rule no. 1
So we are back to defense after Growth and Income. The investments in both Growth and Income have a symmetric risk associated with them – higher the potential for growth/income, higher is the risk.
The stock market, real estate, cryptocurrencies and even Gold are all volatile and go through boom and bust cycles, some cycles are very short (crypto) while others are longer (real estate, gold).
Similarly the assets generating income are typically illiquid and cannot be readily cashed out, when needed.
Thus to preserve long term capital and not getting caught in a downturn when a person needs the money, all investments should not be in Growth or Income bucket. There is a place for very safe investments, where the upside is more than plain savings account but the downside is essentially zero.
Traditionally, financial advisors recommend bonds to provide the safety cushion. However bonds have credit risk, duration risk and interest rate risk. An in-depth discussion of bond risks are below.
I am at a life stage where I am still more than a decade away from retirement, but also feeling the need to preserve my hard-earned money. I am researching different products to limit or eliminate the risk in this part of my portfolio.
The following can be products guaranteeing some upside while protecting the downside.
- Safe growth or Hybrid annuities
- Traditional insurance growth products
- Liquid bond funds (very short duration)
- Cash value life insurance
At present, I only own Short Term Bond Funds and researching the other options for benefits, fees and liquidity.
The world of investment products and advice is mind-boggling. If a person has $50000-$100000 cash and want to start investing, it is not an easy job to know where to start.
This post has shown a way to think about investment in a structured and holistic way. Instead of selecting randomly, a person with $100,000 with $5000/mo expenses can start with the following simple portfolio.
- $15000 in a savings account in an online bank – Emergency Fund
- Additional $10000 in savings account adjacent to checking – Sustenance Fund
- $50000 – Low cost S&P index fund – Growth (in tax advantaged accounts preferably)
- $10000 – REIT or Dividend Yield ETF – Income
- $15000 – Liquid Bond Funds – Safety
Now each month, more money can be invested in the 4 buckets depending on individual goals.