Investment planning

Recognizing that every store of value, even a mattress, is an investment with potential risks and rewards, then anyone who possesses something of value is an investor. A natural first question, then, is, "How should I invest?" That is, into what asset classes should I place my funds and in what proportions? Or, what should my asset allocation be and how do I determine it and adjust it over time? The discussion below attempts to provide guidance in addressing that question using the canonical example of saving for retirement. However, one can use the same techniques for other savings goals. Investment is risk. It is not possible to separate the two. So a natural place to begin is an assessment of one's appetite for risk.

Willingness, Ability, and Need
The canonical measures of one's appetite for risk are willingness, ability, and need. Willingness to take risk is your comfort level with potential or actual loss of principal associated with an expected return. For example, suppose you have $10,000 to invest. Your willingness for risk is how readily you would take the chance of losing some of it for the chance of earning an expected profit. For instance, you might feel comfortable taking the risk of a 50% probability of losing half your investment ($5,000) in exchange for a 50% probability of doubling it (to $20,000). Or you might not feel comfortable with that level of risk but you would be willing to risk a 25% probability of losing half for a 75% probability of doubling it. Your willingness for risk is higher in the first example than the second.

A rule-of-thumb test for willingness to take risk is the so-called "sleep test". Having made or just contemplating an investment decision with a certain level of risk, if you can sleep well at night then it passes the sleep test. You have not exceeded your level of willingness for risk with that investment. On the other hand, if your decisions are causing you unrest you're probably taking too much risk. One's investments should not be a source of discomfort.

While one's level of willingness for risk may be somewhat vague, ability to take risk is more quantifiable. To be able to take risk you need to have something to invest. If you have nothing of value, no money, obviously you have no ability to take risk. But it doesn't stop there. There are certain things a prudent investor should have in place before putting money at additional risk. One is an emergency fund. Another consideration is debt. If you're carrying high-interest consumer or student loan debt it is probably a good idea to pay it off before investing (link to something on paying off debt). While many do not consider it a prerequisite to pay off fixed-rate mortgage debt before investing in other instruments, it may be worth addressing more risky mortgage debt such as adjustable-rate debt or mortgages with balloon payments. Such mortgage instruments can be like ticking time bombs. They could explode just when you do not have the means to make the higher payments. But if your only debt is a fixed-rate mortgage at a reasonable rate, it is not imprudent to consider other investments.

To determine one's ability for risk, one merely has to determine how much in cash one has available to invest. This can be done through a simple household budgeting exercise (link to budgeting). Such a process will reveal how much, per month, you can afford to invest after you meet your other household financial obligations.

Like ability, need for risk is quantifiable but the process of doing so is much more difficult. Need for risk, more than anything else, drives one's required asset allocation. Developing the relationship between need and allocation is the subject of the rest of this page.

Estimating Retirement Income Needs
The goal of retirement investment planning is to build a source of funds (a nest egg) that will generate sufficient income in retirement. What is sufficient? How much income will you need in retirement? If retirement is decades away this seems like an impossible question to answer. Yet, answer it we must, somehow.

Rules of thumb exist. A typical one is that you'll need 70% of your pre-retirement income in retirement. That may be too high or too low in your case. Perhaps a more accurate way to estimate retirement income needs is to plan a retirement budget. A place to start is your current monthly household budget, which you created to determine your ability to take risk, above.

Examining your current budget, you should be able to identify expenses that you will not have in retirement. These may include investing for retirement, investing or paying for children's education, and paying a mortgage. Other expenses may be lower in retirement such as those for transportation (no commuting expenses, possibly owning fewer vehicles) and clothing (no more buying business suits). It is the elimination or reduction of expenses like these that justify an estimate of retirement income below current income. (Note: it is not necessary to make any adjustments for inflation. Compute everything in today's dollars, as if you were retiring today.)


 * Budgeting
 * What to include, what to exclude
 * Other lifestyle considerations
 * Bequests

How to Get Income from a Nest Egg

 * Buying an annuity
 * Safe withdrawal rates
 * What this means for size of nest egg

Estimating Needed Risk

 * How to reach nest egg size
 * Online calculators
 * Assumptions required
 * Being conservative
 * Required rate of return

Risk and Asset Allocation

 * Rate of return and AA
 * Table of historical returns by asset class (see VG website on investment planning)
 * Efficient frontier
 * Many ways to skin the cat
 * Keep it simple
 * Adjustments over time

Final Thoughts

 * Tales of woe from current economic crisis
 * Risk is not your friend
 * Don't fool yourself. You can lose your nest egg.
 * It's up to you to do the work and to get it right.
 * Buyer beware. Understand what you buy.