One of the major projects of this blog is to write a whole series of “How to invest” posts in order to make sure that all our readers have some clear points before they decide to put their money to work. The first two post of the series were: 10 Things you Should know before Investing, and To Invest or Not To Invest, That is the Question. Now it’s time to put out the third post of the series that gets into the second point in our list of the 10 things that you should know before investing, What are you investing for?

I hope you enjoy it

 Before moving forward I want to let you know that this post refers to many of our past posts in order to not explain again some important concepts. 

The market swings that we are experiencing in this beginning of 2016 serve us to be reminded on how important it is to understand which investing vehicles should be used in order to achieve our different investing goals.

Let’s exercise our imagination.

Imagine that in January 2011 you had $100,000 dollars set aside to achieve a particular goal (and that you are leaving in a tax-free world, just for simplicity). You set the goal of buying a car with a cost of $160,000 by January 19^th 2016. Since you know that the average return of the S&P500 in the last 100 years was around 11%, including dividends, you know that, in average, you should be able to have over $160,000 by January 19^th 2016 by investing in the S&P 500.

Fast-forward to July 20^th 2015. The S&P 500 has gone from 1,257.84 to 2,128. You have made 69% return and you have more than enough money to buy your car. You should be happy right? You are! You are so happy that you even think that you might be able to buy another car instead. This one costs $170,000, and since you are only $1,000 dollars away with still 6 months to reach your target date, you decide to go ahead and wait a bit longer.

It is now January 19^th of 2016. The S&P 500 is at 1,881.33. You now feel chills and sweat running through your back. You not only failed to make those $1,000 that will have meant a more expensive car, your return sits now at 49.5% and you are over $10,000 away from your dream car. You can’t figure it out… What went wrong?

• You did not set a realistic investment goal.
• You did not understand how to reach your goal.
• You did not stick to your plan.

These are just 3 of the 5 steps that you should always follow when coming up with, and putting into practice, an Investment plan.

As you can see, failing to follow even a few of the necessary steps for goal investing can result in dreams being shattered. Now it is time to show how we can follow the necessary steps to make sure that our money is always working for us in the best possible way, hassle free and with certainty.

1. Set your Goals

Whenever you want to change the current state of anything, a situation, a service, a product… you need to know what is the end state that you want to achieve. This is what is known as the goal. In investing it’s the same thing. Some of the most common goals are:

• Living a comfortable retirement
• Paying your kids University tuition
• Buying a car
• Going for vacations

If you don’t have goals in your plan you will see how your investments don’t work for you.

1. Make sure you have realistic goals

This is the first step that the car example illustrated where your goal was buying a car. You didn’t have a realistic goal. Why? You didn’t understand the risk/reward characteristics of the market.

Ok, so the goal was not realistic you say… but, how do I know in advance that the goal is not realistic?

Understanding if a goal is realistic can be tricky. In our case, we know that the expected return of the S&P 500 is enough for us to have sufficient money in 5 years to buy the car that we wanted. However, 5 years went by and the amount of money that we had was not enough. Why? Volatility! You can remind yourself of what volatility is revisiting our post Risk in finance and the why of risk management.

The S&P 500 doesn’t have 0% volatility, or in other words, you cannot be 100% certain that every single year it will return a set amount. This is why you cannot set goals with such a specific return rate and expect an investment with high volatility to get you there. This is especially true for those goals that are in the short or medium-term. The definition of medium-term is not clear-cut, I would recommend that anything below 15 years should be considered medium-term.

So what? Well, if you plan to invest with a horizon of less than 15 years you should not be putting your money in risky investments because you might not get the results that you expect. In the case of the car, you could not set a goal in which you need a 60% return in 5 years, either you need more money or a cheaper car (if you want to have a realistic degree of certainty).

1. Understand how to reach your goals (which particular investment strategies you should follow).

At the end of the day it is a trade off that you need to have clear in your head. In the short-term you have to sacrifice expected return for certainty and in the long-term you have to sacrifice certainty for expected return.

What investment vehicles can you use if you have a short-term goal with a specific investment horizon and low risk aversion?

1. Saving accounts
2. Money market accounts
3. Certificate of Deposit (CD)
4. Treasury Bills

(if you want to learn more about this safe investments click on them).

The biggest difference between these investments is in the liquidity and thereturn that they offer. Each of them is virtually risk-free, however, some of them are more liquid than others. Those that are less liquid offer a higher rate of return. Being more liquid means that you can withdraw the money without penalties. In our example we need an investment that gives as a specific amount in exactly 5 years. Since we are not going to need the money before, we can buy a 5-Year CD that returns 2.45% per year. How much money do we need to put in order to have $160,000 at the end of the 5 years: $141,762. As you can see, at the moment, these safe investments do not provide that much return. CDs are returning 2.45% APY (average per year).

If you were not sure if you would need the money before the 5 years you could put it in a saving accounts, currently yielding around 1%. If this was your choice you would need to put $152,234 in the savings account in 2011. As you can see, the difference between the initial amounts that you need to put in the investment vehicle, depending on which one you pick, is sizable, $10,472. Knowing your options, what is your investment horizon, and your liquidity needs makes a huge difference.

In different situations you will need different investment vehicles. If you are saving for your retirement and you are 25, you know you can take on a higher level of risk but you will also enjoy way higher returns. When your investment horizon is 30 years, you can be quite certain that your investment will grow at the expected return rate even when accounting for volatility (there might be exceptions in particular countries, but nowadays it is easy to geographically diversify your portfolio).

Check out this graph of the DJIA (It only represents the U.S. market, but it serves to illustrate the point).

Source: Macrotrend

Even if you invested a lump sum in the peaks, 1929, 1965, 1999, 2008, 30 years later (excluding 2008) you would be enjoying pretty decent returns. This is if you were unlucky enough to invest all your money in a peak. Normally, long-term investors use techniques such as DCA or even the more modern VA (if you want to learn about this investment strategies check our article Investing during corrections: DCA and VA). This will prevent you of investing all your money in market tops.

We said that for the short-term the most important characteristic is risk, what about for the long-term? Diversification. Those that don’t have the time and knowledge to study the market and actively manage their portfolio (the vast majority of investors) should be investing in funds and ETFs that provide exposition to different asset classes and equities from different regions to have a proper level of diversification and make sure that they have the maximum level of return for a particular level of risk. Check our article Yes we can… Diversify to know more about it. You can take on a higher level of risk when you have a long-term investment horizon, however you should never take unnecessary risks.

Investment vehicles that can help you to achieve higher returns and a good level of diversification are:

• Equities
• Bonds
• Commodities
• Real Estate
• Private Equity
• FOREX

It is key to understand that rebalancing is going to be necessary because your investment horizon is going to be decreasing every year. If you started a portfolio at 25 and you expect to retire at 60, at 55 your asset allocation cannot be the same as the one you started with. Now your long-term portfolio is more short-term, so, you should make the necessary adjustments (sacrifice expected return to get more certainty on returns). 

1. Always have clear goals

This might seem redundant, but it is not! We talked about having realistic goals, but you also need clear goals. It is more important than what you may think. It is important due to a few reasons

1. It is easier to stick to them
2. It prevents you from falling into FADs.
3. You will be able to sleep better at night

When you have clear goals you will be able to have your money in the proper vehicle without moving it around for any minor unforeseeable event. If you did your due diligence properly, if you picked the adequate investment vehicle, if you have your safety net and you planned your finances diligently, then you won’t need to be continuously moving your investments around. This is really important, not only because you allow the power of compounding to do its job, you also incur in less fees, which can really eat your returns (we will dedicate an entire post to this in the future).

In the investment world every once in a while, lately all the time, someone comes up with a new trend and the herd behavior makes the average investor follow without thinking twice about it. Investors and financial advisers will come with a new way of making money that gives you better returns and have less risk (or so they say). If you have been reading us you have already learned to always be really skeptical about these investment opportunities.

The markets are not stupid. Traders and brokers make sure that this type of opportunities don’t come that easily to the average investor. The big players take care of any arbitrage opportunities and if there is an investment that has a lot of alpha (a high level of excess return for a determined amount of risk) they will make sure to crowd it before we can access it at a good price. This is why you should not fall prey of these people that want you to put money in “magic investments.”

When you have a clear and realistic plan you will not be nervous about how your money is performing. You will know how much you are risking and why, so you will be able to sleep like a baby! 

1. Stick to your path

This step goes hand in hand with the previous one. Having a clear goal will help you to stick to your path. However, there are going to be times when you are going to want to change your actions, just like in our example. You already had enough money to buy your dream car, but suddenly you became too greedy and wanted a more expensive one. It is true that sometimes you are going to have to revisit your plan and make adjustments, but most often than not you are going to come to the conclusion that it’s better to stick to your guns. This is why we need to remind you how important it is to be faithful to your plan.

Sometimes you will need to fight your desire to follow others’ investments. Whenever you see a particular investment outperforming yours you are going to feel that you pick the wrong one. You know, the grass is always greener on the other side… Most of the times if you see an investment outperforming others, this investment is about to tank, check out our article about bubbles to understand this point: The Chinese Bubble Explained.

It is true that in some cases your portfolio would do better if you changed something, but timing the markets is a tough and dangerous job, you don’t have time to study the investment with the depth that it requires in order to know if you actually need to make changes in your portfolio. This is why the best thing for the average investor is to stick to the plan and make proper adjustments for changes in the risk/reward condition.

Up to here with today’s post. In the next post of the series we will discuss the following statement: There is no return without risk.

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