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, some (not all) of the techniques and tools presented below can be applied to 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.[ Note:Reference required] Willingness to take risk is your comfort level with potential or actual loss of principal associated with an expected return. For example, suppose a hypothetical investor has $1,000. His willingness for risk is how readily he would take the chance of losing some of it for the chance of earning an expected profit. For instance, he might feel comfortable taking the risk of a 50% probability of losing half the investment ($500) in exchange for a 50% probability of doubling it (to $2,000). Or he might not feel comfortable with that level of risk but would be willing to risk a 25% probability of losing half for a 75% probability of doubling it. His 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. Before putting funds at risk a prudent investor should consider taking the following financial steps:


 * Establish an emergency fund;
 * Pay off high-interest consumer or student loan debt; (See Paying down loans versus investing)
 * Pay off adjustable-rate debt or mortgages with balloon payments.

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. Your budget should include every regular source of income (including salary, wages, interest, regular gifts, and so on) and every expense (including taxes, health insurance premium, payment of debt, food and lodging costs, and so on). Good places to start are your pay stubs and tax return. Your bank statement and bills will provide most of the rest of the information you need. See household budgeting for details and examples.

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. A typical one is that you'll need 70% of your pre-retirement income in retirement. 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 should create to determine your ability to take risk

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.

On the other hand, there may be expenses that increase in retirement. You may plan to take more trips or to buy a vacation home. Your health care costs may be higher as you age. To the extent you expect increased or additional expenses in retirement, you should increase your budget.

Some retirement income needs may be met by sources you do not directly control, such as Social Security or a pension. Each year the Social Security Administration used to send each tax payer a statement that estimates their expected Social Security benefit upon retirement. In 2011 it was announced that the mailings would cease and you could now find the same information on the Social Security website. Assuming no future changes to Social Security benefits, part of your retirement income needs will be met from this source. (Relying on Social Security, like relying on future tax law, is a form of political risk.)

Note that if you also expect a pension, you can reduce your needed income by that amount. Be careful though, while Social Security benefits are indexed for inflation, not all pensions are. If you do not have an inflation adjusted pension then the income benefit of your pension goes down in real terms over time. If this is the case, see inflation adjustment for guidance. For the remainder of this page we assume no pension benefit for simplicity. (Incorporating an inflation-adjusted pension can be done in the same manner as a Social Security benefit.)

Source of Income: Nest Egg
Knowing what income you need to generate for retirement,the next issue is how to provide it. The source will be your nest egg, that is the sum of your financial assets at time of retirement, and the income you receive from social security and pensions. How large a nest egg do you need to generate a certain income? A full answer to this questions depends on several factors, including:


 * 1) what return on your investments you receive during retirement
 * 2) how long you will live
 * 3) whether you have a goal of leaving a certain sum for your heirs, among others.

Assuming a $50,000 retirement income requirement we can estimate a capital accumulation target. Assuming a retirement time span no shorter than 30 years and a 3& withdrawal rate (Studies based on past market performance have shown that a 3% SWR is conservative, even over a 30 year period and for a wide range of  asset allocations (AAs).

Dividing the required income by the withdrawal rate supplies a target capital requirement.

[Eqn. 1] retirement income = SWR x (nest egg size)

where the "retirement income" is in constant dollars. This implies that for a certain target retirement income the nest egg needs to be

[Eqn. 2] nest egg size = (target retirement income) / SWR.

Thus, a $50,000 retirement income target would require $50,000/0.03 = $1,666,666.

There are two important points. First, the nest egg so calculated is in today's dollars. By the time of retirement inflation will have reduced the purchasing power of a dollar considerably. We will actually require a higher retirement income in nominal dollars and a correspondingly higher nest egg. Inflation will be accounted for below when we calculate the required return on investment to build the nest egg.

The second important point is that the nest egg size implied by this calculation leaves little margin for error. If you end up needing more income than you thought then you'll need a larger nest egg or you'll have to increase your withdrawal rate. If you must do the latter you increase longevity risk. However, one should view the nest egg size as calculated above as a lower bound on what will be required to support the level of income expected to be needed in retirement.

Having established the required nest egg size, we turn to the next step: to design an investment plan to build a nest egg of this size over the amount of time left until retirement. Before addressing this issue, it is worth mentioning another approach (or set of approaches) to providing retirement income: annuities. See Variable Annuity, Fixed Annuity, Immediate Variable Annuity - SPIA, and Immediate Fixed Annuity - SPIA.

Estimating Required Return
Use a simple broadly based example, or set of examples showing general principle. should only take two or three paragraphs at most.

Subsequent editors of this page may find the examples I already wrote in an earlier version helpful. Sewall 19:29, 4 March 2009 (UTC)

Asset Allocation: Returns and Risks
The problem of asset allocation (AA) is to determine what assets in which to invest and in what proportions. The selection is guided in large part by one's need for risk. AA is a deep topic that has received considerable attention by many finance experts and academic investigators (see the Asset Allocation Category). This discussion deals only with the highest level AA problem: that of selection proportions of stocks and bonds in one's portfolio. In addition, we only consider stock and bond mutual funds or  ETFs and for simplicity we only focus on funds investing in US equities and bonds.

Stock and bond funds have different expected risks and returns. The main risk associated with stock funds is market risk. Bond funds can face a variety of risks: inflation risk, interest rate risk, credit risk. Either type of fund, if actively managed, can face management risk. Overall, any portfolio faces under-performance risk.


 * Rate of return and AA: Asset Class Returns and Historical and Expected Returns
 * According to the Vanguard website, from 1926-2007, the average annual return for bonds was 5.5% (best year 32.6%, worst year 8.1%, years with loss: 13). The average annual return for stocsk was 10.4% (best year 54.2%, worst 43.1%, years with loss: 24).
 * Efficient frontier
 * Many ways to skin the cat
 * Keep it simple
 * Adjustments over time

Troubleshooting and Adjustments

 * What if required rate of return is unreasonably high?
 * What if inflation skyrockets?
 * What if Social Security benefits are reduced?
 * What if my expected retirement income needs change?
 * What if we enter a vicious bear market?
 * How often should I revisit and adjust?
 * The long view: 20-40 years out.
 * The red zone: 20 years out.
 * The goal line: 10 years out.

Final Thoughts

 * 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.