Investment selection plays an important role when transferring bad debt to good; this is where modern investment fundamentals support astute decision making.
[Modern investment fundamentals are explained in Strategy #4 of the Top 5 Wealth Creation Strategies eBook]
Step three in the process of reducing debt and building wealth for clients is where my team and I align client’s financial goals with the appropriate asset selections.
Because a one-size-fits-all investment plan does not exist there are 3 areas that help my team better understand the financial circumstances of a client prior to investment selection:
- Time horizon
- Risk Tolerance
- Asset allocation
These 3 areas enable my team to balance investment affordability, against growth potential, investment volatility and client goals.
Understanding the role these 3 areas play in your investment selections can be the difference between your wealth benefiting from long term market growth or your portfolio falling like a house of cards.
1. Investment Time Horizon
Time horizon is the length of time over which an investment is made or held before it is sold – could be seconds through to decades and depends on an investor’s objectives.
Generally speaking an investor can afford to be more aggressive with a longer time horizon e.g. an investment property may be suited to a 30 year old with a 30+ year time horizon than someone who is 2 years from retiring.
With a goal of reducing mortgage debt (avg. mortgage being 25 – 30 years) and building wealth, it is likely the time horizon will exceed 10+ years.
Time in the Market
Astute investors with time on their side benefit from growth, upon growth upon growth, especially those who start early.
When Albert Einstein was asked what the most important thing he learned from mathematics, he replied, “Compound interest. It’s the most powerful force on earth.”
See compounding in action on a $200,000 investment across various growth rates…
Observation #1 – The performance difference between 4% vs. 6% growth over 30 years is $500,019.
Observation #2 – The performance difference of 5% growth over 10 years vs. 30 years is $538,609.
This may be the reason I have not met anyone yet who has saved him or herself rich!
In addition to compound growth, time in the market offers major tax advantages, lower risk potential and can deliver higher returns for investors who know how to keep investment costs down.
For this reasons my team and I often target investments with strong growth potential for clients with longer time horizons.
2. Risk Tolerance
Risk tolerance is the degree of variability in investment returns that an investor is willing, or can afford, to withstand.
Other factors affecting risk tolerance are time horizon, future earning capacity, and income from other assets. In general, greater risk can be taken when there are other, more stable sources of funds available.
See the risk profiles for these major asset classes…
Observation #1 – In the first year all asset classes have a higher potential for returns and losses, this is reduced the longer the investment is held.
Observation #2 – By year 10 the volatility of asset classes evens out and the gap between the highest and lowest returns closes along with the potential for loss.
An unbalanced investment approach can increase risk and compromise long-term growth due to forced sales.
A realistic understanding of your own willingness and financial capacity to stomach large swings in the value of your investments will influence asset selection.
When there is debt associated with an investment, even with longer time horizons, my team and I will look for growth investments with reliable yield (income).
3. Asset Allocation
Asset allocation attempts to balance risk against returns by managing the mix of assets in an investment portfolio according to an individual’s time horizon, risk tolerance, affordability and financial goals.
Diversifying to lower risk levels
When it comes to financial management, no single investment will continually outperform all other investments all of the time. To minimise potential losses and to smooth investment returns over the longer term, the Nexus Private team spread investments across asset classes.
10-year performance on popular asset classes…
Note: Timing the markets or picking the winner each year is near impossible
In relation to the financial goal of reducing debt and accumulating wealth – balancing high growth potential, acceptable risk levels and long-term affordability can be challenging.
- Where cash and fixed interest have lower growth rates, there is lower risk associated (evident in the table above).
- Property and shares have historically performed well for income and growth and come at the cost of higher risk levels over the short term.
Building a diversified investment plan means the inclusion of different assets—stocks, property, cash or others—whose returns haven’t historically moved in the same direction, and, ideally, assets whose returns typically move in opposite directions. This way, even if a portion of your portfolio is declining, the rest of your portfolio, hopefully, is growing. Offsetting the impact of poor performance overall.
To reduce debt and build wealth, my team and I consider a mix of asset classes and both shares and property are popular choices for the income and growth qualities.
Below is a list of advantages and disadvantages associated with each:
Investing in Shares
Investing in Property
It is important to have a plan for your investments that provides a framework for investment selection to balance affordability and growth against financial goals; in addition regular monitoring and evaluation intervals should be in place to track progress towards financial goals.
Balancing The Financials Against Asset Value
Balancing yield, growth and investment affordability against personal financial goals ensures the transition from healthy finances to wealthy finances is achievable for our clients.
Identifying investment affordability requirements is the next step in the process.
In my next post I explain the process of matching cash flow requirements with investment affordability … [Click here to read]