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The tenets of personal financial success (Proceedings)
Personal financial planning is the process of organizing your financial goals into a workable plan so that you can live with financial security in the style you desire.
Personal financial planning is the process of organizing your financial goals into a workable plan so that you can live with financial security in the style you desire. It involves proper handling of cash flow, assets, and liabilities. Financial planning is the way to get from where you are now to where you want to be. It brings the future into the present, while there's still time to do something about it. To quote Peter Drucker, "the best way to predict the future is to create it."
The planning process is straightforward:
1. Determine what you have.
2. Determine what you want.
3. Determine how to get what you want, using what you have.
Determining what you have involves preparing a Personal Financial Statement. This document lists your assets, liabilities, and net worth. Also, a Cash Flow Statement may be prepared. This document tracks your personal cash receipts and disbursements over a period of time.
What do you want to achieve? Do you have short-term financial goals (e.g. eliminating credit card or other high-cost consumer debt, building an emergency fund, buying a car or home, starting a regular investment plan)? What about your long-term objectives? What are your lifetime goals? What must you accomplish in life? How do you enjoy spending free time? What are your hobbies? Are there hobbies you've not pursued, or that have gotten rusty from inactivity over the years? Visualize how you would spend time if money were of no concern. Where are you? What are you doing? Although each of us conjures up a unique picture, we often have many of the same thoughts:
- Financial independence (you are not dependent on the state or federal government, your children, your parents, or your paycheck).
- No financial worries.
- Own a nice home
- Help children get a college education.
- Own a nice vacation property
Many people find their vision of the future is unrealistic, given their modest level of saving and investing. Many find they need to modify their expectation of the future. Although this process may be a bit humbling, it should not discourage you. It's far better to modify you expectations, and have an accurate picture of the future, than to have no idea whether or not your picture is feasible. If you remember nothing else, remember that it is never too late to begin. Start today.
What are the biggest threats to your future financial security?
- Doing nothing.
- Failing to diversify
- Investing too little.
- Investing too conservatively.
- Failing to insure against catastrophic risks.
Why doesn't everyone plan for their financial future? Common reasons given include:
- "I don't make enough money. My income level doesn't warrant planning."
- "The future will sort itself out."
- "I've already waited too long. It's too late to start now."
- "I'm afraid of what I might find. The truth might be painful."
- "When I win the lottery, it won't matter anyway."
In fact, retirement planning is probably more critical for people with modest income than for the very wealthy. I'm sure we can all think of people in their 'golden years' who are not enjoying an idyllic existence. What's the good news? Each of us has the power and ability to profoundly influence our personal financial future. We can do something about it.
The first, and most important rule of retirement planning is to pay yourself first. If you're under age 40, set aside at least 10% of your income each year. If you're older and haven't started investing, you may need to set aside a higher percentage. The easiest way to do this is to set up an automatic withdrawal or transfer from your bank or checking account. On a certain day each month, have 10% (or more) of your monthly income subtracted from your account and transferred to a high quality, no-load, low-cost mutual fund. The idea is simple – you can't spend what you don't have. After all, it's human nature to spend all our disposable income. For proof, recall how quickly your expenses increased the last time you got a pay raise! All of the sudden, it was time to buy that new car or bigger house.
According to an American Animal Hospital Association (AAHA) Veterinary Career Survey, retirement potential ranked above average in terms of importance, and below average in terms of satisfaction. Increasingly, people are focused not just on how to meet this month's payments, but also on their longer-term financial goals and objectives. Common examples include funding a child's college education, and achieving financial independence. Financial independence is that point in time when you have acquired sufficient assets to spend time however you choose. It doesn't matter whether you choose to continue working, or hang it up and travel the world. Having sufficient resources allows you the freedom to do whatever you want. With the aging baby boom generation, unprecedented numbers of people are closely considering their financial future.
Before You Invest
Don't even consider investing until your financial house is in order. For example:
- Are potential catastrophic risks covered by insurance? Do you maintain adequate health, life, disability, long-term care, property and casualty, and professional liability insurance?
- Do you have an ample emergency fund? Have you arranged access to cash totaling three to six months of living expenses? Have you considered any large expenses you might incur in the next year or two? Do you have any tax payments due soon? Will you have to replace that old car in a year or two? When is the next tuition payment? You don't want to be caught short of cash and be forced to liquidate a long-term investment to pay for a short-term need.
- Do you carry a zero balance on all your credit cards?
If you thoughtfully and honestly answered 'yes' to these questions, investing may be suitable for you at this time.
Basic Principles For Successful Investing
What do you want to achieve with this money?
Are you setting this money aside for a child's college education? Is it for your retirement? Are you saving for a new car? A new home? Will it be used to buy into a partnership, or to start your own practice? You shouldn't invest until you know what you plan to buy with this money – albeit that may change as time passes. Ultimately, your objectives for this investment will boil down to safety, current income, long-term growth, or some combination thereof. Once you know your purpose in making the investment, you'll quickly eliminate many inappropriate alternatives.
Diversify Your Assets
Have you prepared a personal financial statement recently? If you're a practice owner, when was your practice last valued? What percentage of your total assets are tied to the practice - including the land, building, equipment, leasehold improvements, furniture and fixtures, and goodwill? If you're like most veterinarians, the vast majority of you eggs are in one basket. This exposes you to inordinate and unnecessary risk. Also, recognize that your practice is an illiquid asset, it is not easily or quickly converted to cash. By diversifying into more liquid assets such as stocks, bonds, and cash reserves, you can mitigate this risk. I don't infer that you should hesitate to invest in your practice, I believe you must do so continuously to be successful. However, it's critically important that you spread your assets among more than one basket.
Next, determine an initial investment allocation among stocks, bonds, and cash reserves. The proportions that you choose (your "asset mix") should depend on your objectives, time horizon, and risk tolerance. Time is particularly critical since the longer you have to invest, the more risk you can accept. Keep in mind that your asset mix, not your individual investment choices, tends to have far greater long-term impact on your investing success. Unbelievably, one renowned study showed that 94 percent of investment performance depended upon the asset mix. Only 6 percent of investment performance depended upon which specific investment was selected or when the investment was made. Why is asset mix so important? Consider the following historical performance:
Compound Annual Returns (1926-2006)
Small Company Stocks 12.7 percent
Large Company Stocks 10.4 percent
Long-Term Government Bonds 5.4 percent
Treasury Bills 5.3 percent
Inflation 3.7 percent
Source: Ibbotson Associates, 2007
Past performance is no guarantee of future results
Over the past 80 years, commons stocks have clearly outperformed the other asset classes.
How much of your liquid assets should be devoted to equities (stocks or stock mutual funds)? A rule-of-thumb is to subtract your age from 120, and place that percentage in stocks, or stock mutual funds. For example, a 40 year old might place 80% of his or her liquid assets in equities. But, depending on your investing temperament, you may be comfortable with more or less risk. Additionally, your particular financial situation may dictate a higher- or lower-risk approach. This rule-of-thumb also assumes that you are willing to tolerate short-term ups and downs in the stock market in pursuit of higher returns over time. Note that as you move closer to actually spending your money, your emphasis should gradually shift from growth-oriented investments (stocks) to income-oriented investments (bonds and cash reserves).
How much risk can you accept? This is one of the toughest questions for investors to answer. Risk doesn't bother any of us until we begin to lose some money. As you study an investment, find out the worst it has ever performed. A stock or mutual fund with one great year can look good even if performance before and after that were miserable. That impressive three, five, or 10 year performance record may be masking some real ugly years. Does the investment you're considering give a smooth ride or fluctuate wildly from year to year? Picture yourself in this investment after it has lost some of your hard-earned money. How do you feel? If this thought makes you uneasy, nauseous, or unable to sleep at night, it's time to find another candidate. If you invest outside of your risk tolerance or comfort zone, you'll probably be tempted to dump the fund at the worst possible time – after a big fall. On the other hand, many people invest too conservatively and will find it difficult or impossible to meet their long-term goals and objectives. This is especially true in Individual Retirement Accounts and employer sponsored retirement savings plans, where the money is typically out of grasp until you reach age 591/2 .
Distinguish Between Saving and Investing
Saving is short-term, investing is long-term. Saving may guarantee you a specific dollar amount by a certain date, investing most surely will not. Saving will usually result in a loss of purchasing power over time, investing should result in increased purchasing power over the long haul.
Very often, having money in a 'safe' refuge has actually resulted in no real gain in purchasing power. Not that you shouldn't have money in the bank, just don't expect that it will outpace inflation on an after-tax basis. However, money that you anticipate needing in the short-term (less than five years) should definitely be stored in a safe haven.
I am often asked whether it makes more sense to buy individual stocks or rather, to buy stock mutual funds. In almost all cases, I have a strong preference for stock mutual funds. The reasons are many, not the least of which is that credible research indicates that one would need between $2 and $3 million dollars in liquid assets in order to adequately diversify by purchasing individual stocks. Needless to say, few enjoy this enviable position.
Start Investing as Soon as Possible
Time in the market matters - timing the market does not. Timing the market is an unqualified myth, yet reasonable people will survey overall market conditions before investing (as in, "the market is awfully high right now, I think I'll wait until it comes down a bit before I invest my hard-earned money"). This research, even if nothing more than a gut-feel, is a colossal waste of time. Think of the millions of frustrated investors who maintained that mindset and sat on the sidelines from 1995 through 1999 – arguably the best five year period in the history of the U.S. stock market. The truth is very simple – no one, repeat no one, knows the near-term future of the stock market. To guess is futile and humbling. So we consistently believe that "now" is always a good time to invest.
Of course, there are many hundreds of investment newsletters and market-timing services which purport to know the unknowable. Before heeding the advice of these heresy publications (we call them financial pornographers), ask yourself a few questions: Why do they need to sell subscriptions to their timing service if they have it all figured out? Is 100 percent of their personal money invested as they advise? Was the company yacht and airplane purchased on astute market timing, or subscription revenue from the newsletter's trusting followers? Suffice it to say that there is no credible research indicating that market timing is possible or profitable. Market timing is a fool's errand. No one now living or dead has ever consistently guessed the market's next move.
Time in the market is THE SINGLE most important factor in terms of investment success. Time can be your greatest ally, or your worst enemy. No matter the existing market conditions, today is a good day to invest – not as good as yesterday, but much better than tomorrow. Lost time is never found.
Sure and steady wins the race. It matters less where you start. It matters more that you start. Starting is what counts. As you choose your investments, consider a dollar-cost averaging strategy of investing a set dollar amount on a fixed schedule, regardless of market conditions. This strategy will allow you to acquire more shares at lower prices than at higher prices. Of course, the practice of dollar-cost averaging does not ensure a profit or protect against a loss in declining markets. You must also consider your ability to continuously invest through periods of low price levels.
An easy way to invest regularly is to establish an automatic investment plan with a mutual fund company whereby a certain dollar amount is transferred from your checking account, your savings account, or your paycheck to a mutual fund account on a fixed schedule (e.g. weekly, bi-monthly, monthly, or quarterly). The beauty of this approach, in addition to all the benefits of dollar cost averaging, is that it makes budgeting unnecessary. This investment is on remote-control; it is regular, constant, automatic, disciplined, and unconscious. In short – it works!
This strategy is sometimes known as "paying yourself first." You effectively treat yourself like any other creditor. It's human nature to spend at least 100 percent of our income. Most of us have too much month at the end of our money. However, you can't spend what you don't have. If you consistently set aside 10 percent of your paycheck (more if you're older and haven't started investing yet) for long-term growth (invest in vehicles that will outpace inflation on an after-tax basis), you will have applied the Golden Rule of investing - your personal financial future should be bright and your worries few. If you think living on 90 percent of what you make would cramp your lifestyle, just think back to how quickly you adjusted to your last 10 percent pay raise!
Have Realistic Expectations and a Long-Term Perspective
According to the great American philosopher Dolly Parton, "If you want the rainbow, you have to put up with the rain." Unfortunately, conventional wisdom tells us that stocks are risky investments. No doubt, this is due to their day-to-day volatility and the fact that they are not FDIC insured. However, for the long-term investor, stocks are the only option you have to increase purchasing power. For the long-term investor, what could possibly be riskier than bonds and cash reserves where you are virtually guaranteed to lose purchasing power after taxes and inflation? Of course, if you need the money soon (in five years or less), or if you think you might bail out in a storm, you are not a good candidate for the stock market.
Like all companies, mutual funds incur operating expenses. With mutual funds, however, those expenses are passed on directly to you – in effect, lowering your rate of return by the amount of the expense. Therefore, it is important to use efficient funds – those with lower than average expense ratios. This information is easily found in the prospectus. The average expense ratio for a diversified stock fund is around 1.5 percent. Does the fund you are considering operate more or less efficiently? When the stock market is up 20 or 30 percent per year or more (as it was in the late 1990's), a 2.5 percent expense ratio doesn't bother you much. However, in a year when the market returns only 5 percent, fully half your profits disappear. Which is the least costly mutual fund family? Without a doubt, that honor belongs to Vanguard, the second largest fund family. Their no-load mutual funds are notoriously cost efficient. In fact, in his book "Mutual Fund$ For Dummie$," author Eric Tyson argues that if you've found a mutual fund you like, compare it to a similar fund offered at Vanguard. You're decreasing your chances of success if you choose similar performing, but higher cost funds elsewhere.
There are more immutable laws of investing success:
- Avoid load funds
- Buy and hold - don't actively trade
- Take advantage of tax-deferred investing when possible
- Know what you're buying
- If it sounds too good to be true...it is
- Don't let the "tax" tail wag the "investment" dog
- Insurance is not an investment...refuse to invest in insurance products
A new car comes with an operator's manual. Even a simple wristwatch has a detailed "how-to" booklet. However, no one is handed instructions with a paycheck. Managing money is not a skill commonly taught in even the best business schools. You probably will have to learn for yourself, often making the same mistakes as those before you. Just as there are absolute principles about anatomy, physiology and our physical world, there are a few personal financial "truths" which you would be unwise to violate. Unfortunately, most people ignore the immutable laws of personal financial success. Instead, they search in vain for the elusive - and mythical - holy grail of wealth building. Here are a few time-tested rules that you can learn and apply, no matter your age, fiscal situation, or financial literacy.
- Maintain an ample emergency fund to avoid credit card debt
- Prioritze/pay off debts in order (either smallest debt to highest, or highest interest rate to lowest)
- Leverage can work to your great benefit – or your great detriment
- Don't borrow money to buy depreciable assets (e.g. cars)
- It may make sense to borrow money for things that:
• Increase your income
• Increase in value
- Good debt
• Low interest rate
• Tax deductible
- Bad debt
• High interest rate
• Not tax deductible
- Student loans
- Home mortgage
- Other consumer debt
Are you in over your head?
- Consumer Credit Counseling Service
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