Good financial planning decisions extend well beyond where and how you invest. A number of important and complex decisions must be made before you buy a stock, bond, or any other type of investment. Before you do, ask yourself these 7 questions to understand if you are about to make a good financial decision.
Question 1: Why Invest At All?
Before investing it is important to ensure that yur money is being used to best help you achieve your goals. For instance, before you invest and depending on your own personal circumstances, it may make more sense to pay down existing debt, especially high-interest consumer debt like credit cards, as well as to create an emergency savings fund or purchase insurance, rather than investing in the stock or bond market.
“Ensuring this question has been adequately answered should provide an investor with some assurance that investing makes sense for their situation and that they can develop a goals-based financial plan”, says Paul Kaplan, Morningstar’s director of research.
Question 2: What is an Appropriate Risk Level?
Creating a portfolio that is consistent with your ability as an investor to take on risk is a complicated exercise. It is important to consider not only risk preference (i.e., how I would feel or react based on market performance), but also things like risk capacity (i.e., how much risk should I take given my resources and financial situation) and how I may respond to actual market events.
“Regardless of approach, though, ensuring the portfolio is consistent with the investor’s risk appetite is a very important part of the portfolio process”, says Kaplan.
Question 3: How does the Risk of Your Goals Affect Your Portfolio?
People generally invest to fund a specific goal, e.g., retirement paying. Therefore, it’s important to understand how the risks associated with the goal itself should affect the portfolio and include them in the portfolio optimization routine.
Question 4: Which Type of Investment Make the Most Sense?
Different investments have different tax attributes and fees. Therefore, understanding how taxes and fees will affect investing appropriately can increase an investor’s effective returns. If, as an example, a fund manager charges a fee of 1% of assets under management and produces alpha of 2%, the investor enjoys an overall net gain of 1%.
The term “alpha” identifies how a fund manager can combine securities into a portfolio that provides excess returns to investors above the appropriate related benchmark for those investments on a risk-adjusted basis.
Question 5: Which Asset Classes Should You Consider?
After determining the appropriate target risk level, an investor must determine how to construct a portfolio.
“For example, if the investor is targeting an overall equity allocation of 60% of assets, they must determine how to invest in equities (i.e., for a given risk level)”, says Kaplan. “The investor could choose to invest entirely in domestic large-cap equities or create a more efficient portfolio by considering additional asset classes such as domestic small caps, international equities, emerging markets, etc”.
Question 6: What Investments Should You Select?
Once the asset class targets have been set, the next step is for you to determine what investments to select. There are a variety of potential investment vehicles to choose from, such as mutual funds, ETFs, etc., as well as investment strategies (e.g., active or passive). Given the relative difficulty of consistently selecting funds that outperform peers on a risk-adjusted basis, investors should focus on fees and have a proven system when selecting active managers.
Question 7: When Should the Portfolio be Revisited?
Revisiting the portfolio is an important aspect of implementation to ensure the investments remain consistent with the underlying goals and objectives of the investor. “At a minimum, assuming the investor’s goals and objectives have not changed, the portfolio should be rebalanced at least annually”, says Kaplan.
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