The Purpose of Investments

As a financial planner I consider investments a means to an end: To enable you to achieve your life goals. For most people the largest goal is the ability to maintain their current lifestyle throughout retirement and not run out of money. Other common goals include funding primary, secondary and/or higher education for their children, buying a house, and travel. There are of course many others.

So before nailing down an investment plan the first task is to clearly understand your life goals, both short and long term. The purpose of your investments is then to provide the funding to enable you to achieve those goals. And the longer the timeframe you have before the funding is required, the better the chance are they you will be able to fund it.

By its nature this context implies a long term perspective. With such a perspective the daily rantings of market commentators has little meaning. What matters it what is going to happen to your investments long term. So how do you create a long term investment plan that is right for you? There are a number of variables which each affects your plan:

·         Funds required to achieve your goals

·         Value of your current portfolio and how it is invested

·         The rate of return of your portfolio

·         Ongoing savings

·         The risks you face including portfolio risk and the ability to continue ongoing savings.

Assuming the funds required and the value of your current portfolio unchangeable for a moment, then the areas you have to work with to create a realistic plan are your ongoing savings, your rate of return, and your risk. Lets first look at risk and return.

Risk and return are intimately tied. The return a market demands for any security is actually based on the risk inherent in the security. In fact this return is defined as the riskless rate of return, assumed to be a 3 Month Treasury Bill, plus a risk premium representing the various risks included with the security.

Diversification provides the best approach to managing this risk while still providing a reasonable return. By investing small amounts in many different uncorrelated assets overall risk is reduced and a more consistent long term return is achieved. Assets with low or uncorrelated assets will usually behave differently then each other. A period of decline in one area will typically be countered by gains in another area.

The mechanism for providing this diversification is asset allocation. An allocation that includes the optimum amounts of the following asset classes can achieve this diversification: US equities (large and small), international developed equities, emerging markets, multiple types of fixed income, cash, real estate, and possibly some alternative investments.

Determining an optimum asset allocation that is appropriate for you requires an examination of your personal views about risk. It is important to understand your ability to tolerate risk, your capacity to absorb financial risk and the amount of time until your funds are needed. Knowing this an asset allocation can be identified that provides the most return consistent with your risk factors.

With this in hand the last issue is your savings rate. Using appropriate analysis tools or formulas the savings rate required to achieve your goal can be determined, given all the other previously determined factors. If this amount or savings is not achievable then and re-examination of the other factors is needed. Maybe your goals are too lofty. Maybe you can find a way to save more? Maybe you can actually tolerate more risk which will give you a higher return?

The point is that now you are asking the right questions regarding your investments. The purpose is to fund your indentified goals. The mechanism is to establish and maintain an optimally diversified asset allocation plan which provides the proper risk adjusted return for your specific situation.