Deciding on an Investment
The Financialist • Issue 108 • January 2011
BY CLAY GILLESPIE BBA CFP CIM FCSI
What is the first question that comes to mind when deciding on an investment? Is it the rate of return? Is it the safety of the investment? Or perhaps how much it will cost?
While these are all very important questions, the first question you need to ask is: “What is the eventual intended use of these monies?” Investments are only useful when they suit our future plans for them.
Once you've decided on the objective for the funds, you can work back to analyze the various investment options that can best help you achieve your goal. This is the time to address your secondary questions.
Let’s say, for example, that you sell your house today and you plan on buying another house in a couple of years. Where should you invest these funds? Investing is not gambling and should not be seen as a matter of chance or good fortune. Rather, it is the purchasing of financial products with a specific goal for the use of that money. Gambling, on the other hand, is using financial products solely for the sake of gain, without purpose.
In this example, since you will need the funds in a couple of years, having the capital safe and available when you are ready to purchase your new house is more important than the rate of return that you might achieve. As a result, it would be prudent to invest these funds in short-term fixed income vehicles that protect your capital.
It goes without saying that in this scenario, it would not make sense to invest all your funds in the stock market, since the rate of return that you can achieve over a short period of time is unpredictable. The market does not react in a predictable manner over the short term. The most important point to keep in mind is that these short-term stock market movements may have nothing to do with the underlying investment climate.
Since World War II, the average stock market cycle (from one peak of stock market value to the next peak) has been about five years. Keep in mind that this number is only an average which, by definition, means that some stock market cycles have been shorter while others have been longer. Therefore, as a guide, if you are investing funds for less than five years, you need to understand that investing in the stock market can be quite risky. If, however, you have a longer-term investment horizon (eg. retirement planning), the risks of investing in the stock market are reduced.
In your portfolio, it is common to have two or three different investment strategies. You may have an investment that has been set up for emergency purposes and, thus, is invested in a high-yield savings account. In addition, you may have an account that is set up to generate income, and yet another account that is intended to grow over time.
For example, as you approach retirement, your portfolio should be reviewed and likely rebalanced to prepare for generating income when you retire. Since the average stock market cycle is approximately five years, you should start preparing for retirement five years before your expected retirement date. If the stock market is in the middle of a downturn, you will have five years to make the appropriate changes to your portfolio. If the market is not in the midst of a correction, you will want to make the appropriate adjustments to ensure that your portfolio is prepared for when the stock market does correct.
In a typical discussion with a client, I would say that in investment management terms: “Over the next ten years, you will hate me in two of the years, love me in two of the years, and in six of the ten years you will be indifferent towards me.” What this really means is that, on average, two times out of ten, the market will go down dramatically; two times out of ten, the market will go up dramatically; and six times out of ten, the return will be neither good nor bad. Therefore, you need to design an investment strategy that will deal with all of these probable events.
We have a reasonably good idea of what the markets are going to do; it is the when that is difficult to predict. Thus, for a retiring client, we would have enough money in liquid investments to make monthly income payments, enough money in fixed income/conservative investments to fund your income in future years should the market decline in value, and enough money in the growth investments to use for income when the markets increase in value.
Investing is a lot less complicated and more successful if you invest based on objectives rather than only using the expected rate of return. Investing based solely on rate of return will typically lead to decisions that counteract your objectives. Know your objectives before you invest.