July 19, 2019

A Formula for Reaching Your Financial Goals Part 2

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In my article, A Formula for Reaching Your Financial Goals Part 1, I introduced the idea that if you were able to change your mindset and focus on what you can consistently control yourself, develop a plan around those things, and stick to the plan over the long term, you would sleep better at night and have a better chance of reaching your financial goals. I capture the things you can control in what I call the Five-by-Five formula for reaching your financial goals.

In this article, I summarize the principles of the Five-by-Five formula, which consists of five behavioral, and five technical principles. In subsequent articles, I will cover each principle in more detail. I confess, I am not a genius and I did not invent something new that was previously unknown to the financial planning and investing world. I am simply capturing in the Five-by-Five formula those things I have come to believe are the most important that each of us can control. You and I cannot control the stock market, the economy, or major world events but by focusing on these ten principles, we can have a level of control over our investments that I believe makes all the difference in whether we succeed or fail at reaching our financial goals.

I learned these things through my training and work as a CERTIFIED FINANCIAL PLANNER™ professional, through over 25 years of my own personal experiences in planning and investing for the future, and through my own lifelong learning about investing and personal finance starting at age 24. I have also been positively influenced over the years by the writings of experts and pioneers in financial planning and investing including Jack Bogle, Rick Ferri, Nick Murray, Bob Veres, and Bert Whitehead among others. All of these people have contributed to shaping my views and approach to investing and financial planning.

Most People Focus on the Wrong Things

What I have learned through my experiences is that many people focus on the wrong things when putting together their plan for saving and investing for the future. Some common mistakes people make are:

  • Not having a plan that aligns with their unique financial situation and goals. Often times, they simply do what the crowd is doing or what their neighbor, friend, or family member is doing now.
  • Not having SMART goals, which are Specific, Measurable, Achievable, Realistic, and Time bound. One does not have to over analyze everything, but in my opinion, thinking through goals, writing them down, and having some parameters attached to them increases the odds of success.
  • Making an unrealistic target rate of return the primary focus of the plan. A financial plan should start by identifying goals not rates of return.
  • Trying to time the markets based on a variety of different things such as economic forecasts, earnings reports, and betting on the outcome of political events among others.
  • Not understanding the importance of knowing their risk capacity and risk tolerance. See The Importance of Knowing Your Risk Capacity.
  • Going all in and making a high risk bet with all of their money on the stock of one company or putting all of their money into a single business venture.
  • Wanting to get rich quick and not understanding that most people can build suitable wealth over a lifetime of investing and saving that will provide them with a comfortable and happy retirement.
  • Focusing too much on the 24-hour news cycle and getting caught up in the noise from the media and making emotional decisions because of it.
  • Getting lost in the weeds and not focusing on the big picture.

The Five Behavioral Principles

A person’s behavior is likely the single most important factor that will determine whether they succeed or fail at reaching their financial goals. I believe understanding and managing the five behavioral principles below are crucial to reaching financial goals.

Behavioral Principle 1: Controlling emotions – bailing on a financial plan and selling investments when markets go down significantly is a sure fire way to fail at reaching financial goals. The same can be said for when markets are rising and on a tear – many people become afraid they will miss huge returns and thus, they want to increase their exposure to equities without regard to their risk capacity and risk tolerance.

Behavioral Principle 2: Having patience – having the mentality that reaching financial goals takes time and is not achieved overnight is crucial to succeeding. People who want success quickly and who are not willing to accept that it takes time tend to take on too much risk. Then when something goes wrong, they bail on their financial plan.

Behavioral Principle 3: Having faith grounded in knowledge – in my opinion, one must have faith in the future in order to successfully invest and save for the future. When an investor purchases shares in an asset such as a mutual fund or ETF, they must believe in capitalism, believe companies will grow and earn more money in the future, and believe our country will thrive and prosper. If there is no faith, then why bother in the first place? This faith must be grounded in knowledge about how the markets and economy work. You do not need to get a college degree in finance or economics but I believe understanding the basics will help you stick to a plan.

Behavioral Principle 4: Having discipline to stick to a plan – a financial plan is a road map for reaching financial goals. In order for a plan to work, one must stick to it in up and down markets, year in and year out. This is not to say a plan is never adjusted because it is. However, adjustments should be made deliberately and based on reason, thought, and not emotions.

Behavioral Principle 5: Paying yourself first – this might be the most important behavioral principle and one of the hardest for people to implement. In order to build wealth, one must live on less than one earns. It is as simple as that. To live on less than you earn, you have to set aside a portion of your earnings every time you are paid. The trick is you have to treat it like a bill and make the payment to your savings as soon as you are paid. A mistake that many people make is to take the approach that they will wait until the end of the month and save whatever is left over. The problem with this approach is that for most people, there will never be any money left over at the end of the month because they will always find a reason to spend it all. See Quick Answer #2 – What does pay yourself first mean?

The Five Technical Principles

These principles require technical knowledge, deeper analysis and planning, ongoing monitoring, and periodic adjustments. I believe understanding and managing the five technical principles below are crucial to reaching financial goals.

Technical Principle 1: Asset Allocation – how your portfolio is divided up between different categories of investments (asset classes). In working with my clients, I generally talk about three asset classes which are 1) equities (stocks) 2) interest earning (cash and bonds), and 3) real estate but there are others as well. Each of these asset classes has a unique purpose in the portfolio that I will go into in more detail in future articles.

I believe a key factor that can help people control their emotions during the ups and downs of the markets is through having an asset allocation that is appropriate for them. For a simple example, assume someone has 80% of their portfolio invested in equities but is unable to sleep at night and constantly worries about their investments, and then sells their equities when the market goes down 20%. This person has likely exceeded their risk tolerance by being 80% in equities and should probably have less exposure to equities. By selling every time the market goes down 20%, this person is sabotaging their financial plan. I also believe having plenty of cash available to see you through downturns in the markets and to help with emergencies is key to long-term success.

Technical Principle 2: Diversification – within each of the asset classes it is important to diversify among different types of investments. For example, I believe the equity portion of the portfolio should be divided up between U.S. based small capitalization, mid capitalization, and large capitalization stocks, international stocks from developed countries around the world, and international stocks from emerging market countries around the world. I believe the interest earning portion of the portfolio should be divided up between cash (and cash equivalents), treasury bonds, and corporate bonds. At any one time, nobody knows which types of companies or which countries are going to do well or struggle economically. Instead of guessing on any one type of investment, I believe it is better to diversify across many different types of investments in order to spread the risk around. At different times, different investments in the portfolio will be doing better or worse than other investments.

Technical Principle 3: Rebalancing – over time, a portfolio will drift from its original asset allocation. When this happens, adjustments will need to be made to get it back in alignment. For example, assume an investor starts out with an asset allocation of 60% equities and 40% interest earning assets. Also, assume that the equity markets do well over a period of time and this investor’s asset allocation drifts to 80% equities and 20% interest earning because stock prices increased in value while bonds went down in value. To get back to the original asset allocation (rebalance), some equities could be sold and the proceeds added to the interest earning part of the portfolio.

Why is it important to rebalance? Asset allocation drift changes the risk being taken in the portfolio and as a result, the portfolio may no longer align with the investor’s risk tolerance or risk capacity. Rebalancing will help the person stick to their financial plan and sticking to a plan is key to long-term success.

Technical Principle 4: Being tax aware and tax efficient – when I meet with prospective clients the first time, I ask them to bring their last three years’ tax returns to the meeting. I do this for several reasons. Number one – by reviewing someone’s tax returns I learn more about them both personally and financially. Number two – sometimes I find an opportunity to help someone correct an error in their tax return that will save them money. On occasion, I find a mistake in a tax return that will cost someone money to correct but at the same time, it may also save them from having an issue with the IRS later on.

Often times, when I meet a new prospect I learn that they experienced an unexpected tax surprise in a recent tax year and had to pay a large tax bill to the IRS. This happens when someone is not aware of his or her tax situation until it is time to file his or her tax return. I believe it is important to do tax planning throughout the year to avoid unexpected surprises and proactively manage the tax bill.

I tell my clients that almost every financial decision they make has an impact on their taxes in one way or another. When drawing money out of an IRA, selling investments in a brokerage account, buying or selling a house or other asset, it is important to know the effect on taxes. Proper planning can help identify opportunities to legally reduce or eliminate taxes that occur because of the transaction.

One example of being tax efficient is to hold interest earning assets in a traditional IRA or qualified plan, i.e., 401(k), 403(b), and equities in a brokerage account (asset location). The tax efficiencies come from the fact that equities in a brokerage account will be taxed at more favorable long-term capital gains rates if held for at least one year and a day while interest earning assets will generally be taxed at ordinary income rates the same as traditional IRA and qualified plan withdrawals. Practically speaking, this is not always possible to achieve as many people have accumulated most of their assets for retirement in 401(k)s, 403(b)s, and IRAs and do not have substantial assets in brokerage accounts.

The key is to be constantly aware of your tax situation; know the impact financial decisions will have on taxes and proactively manage the outcome where possible.

Technical Principle 5: Keeping expenses low – in general, I believe in investing in low cost passive index mutual funds and ETFs. Historical data shows that over long periods of time, actively managed funds do not consistently outperform the benchmarks they are trying to beat. Index mutual funds and ETFs generally have lower expense ratios than actively managed funds. The expense ratio is the annual fee charged to shareholders. As an example of the cost savings that can be achieved, if $500,000 were invested in a portfolio of actively managed mutual funds with an average expense ratio of 1%, the average annual expenses on the portfolio would be $5,000. If $500,000 were invested in index mutual funds with an average expense ratio of .10%, the average annual expenses would only be $500. Over time, these savings add up.

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