The marketing of financial products has caused investors to focus too narrowly on the details of specific investments. As a result, most investors fixate on asking the wrong questions and fail to ask the strategic questions necessary to tailor their investments to best reach their life goals.
The financial services industry has been largely built around selling financial products. This is an unfortunate history and has produced financial salesmen who are sometimes more interested in describing the attributes of their newest 5-star mutual fund or top-rated annuity contract than in listening to your life goals. Even those who do listen can rarely meet your goals using only their commission-based wares as the fees on those products are too high.
A good advisor begins comprehensive financial planning by understanding your personal goals, attitudes, and values. Every financial decision and investment should be made within the bigger context of your life goals.
Purchasing investment products in isolation from the larger context of your specific situation is like pushing random buttons on a vending machine in order to provide a Thanksgiving dinner for your family.
In financial psychology terms, this error is called “narrow framing.” If your investments are not tied directly to your life goals, you and your advisor could be making this common mistake.
Letting your goals drive your investment decisions will mean you stop asking shortsighted questions like: What industry is set to do well in the next year? or Where is there real money to be made?
Instead, you will start by asking questions that are specific and personal such as: What asset allocation and investments will best help me meet my financial goals? or Am I saving or moderating my spending enough? or Am I on track to meet my goals?
Financial planning begins with the question “What is the money for?”
We have clients who answer that question in very different ways. As a result, we structure their finances differently.
For example, a client may be interested in having enough assets at age 50 to leave their job and become an entrepreneur. Another client may be most interested in supporting specific charities. Another may want to structure their estate to preserve the value and integrity for future generations. Another client may wish to provide an endowment to cover college education costs for their grandchildren.
Mathematically, many client goals can be simplified into a necessary current or future withdrawal rate. For most of us, we want to spend our money at some point, that is why we are saving or have saved it, and we also don’t want to run out of money. As a result, the withdrawal rate is at the center of most goals. The average worker is saving now, so that they can meet their living expenses when they retire later, and they want to have enough money to maintain that standard of living for their entire lifetime. Thus, their future withdrawal rate is at the center of their goals.
We most frequently use withdrawal rate to design our custom asset allocations for clients. As explained in our article “Your Asset Allocation Should Be Priceless,” there is an optimum allocation between stocks and bonds for a given withdrawal rate. This is how we build asset allocations.
If a withdrawal rate is not part of your goals — because you are able to live off of your pension for example — then your goals can normally be categorized mathematically as either the desire to maintain your wealth or grow your wealth. Without a withdrawal rate to meet, your optimum allocation between stocks and bonds is based instead on your appreciation goals or your volatility tolerance. Because you don’t need the assets, you have the leisure to pick an asset allocation that is either more aggressive or more conservative that others your age.
If you don’t have a target asset allocation tailored to meet your goals or if you haven’t rebalanced to that target recently, you may need some objective strategic advice that isn’t driven by selling you more products. If you know how the individual investments you own are doing, but you don’t know the time-weighted return of all your investments as a total portfolio, you may need to step back and look at the bigger picture.
You should seek professionals who provide comprehensive advice in the context of your specific situation and objectives.
If you put too much focus on picking the right investments, you are liable to do the wrong thing with your portfolio as a whole. It is easy to be like a gambler who regrets betting so much on an individual hand of poker. In reality, he shouldn’t have sat down at the table in the first place.
Strategic financial planning begins with your specific life goals. These could be as simple as wanting to retire at age 55. Most likely your goals are much more complex and detailed. It is okay to develop both your asset allocation and your goals gradually over time. It is a rare person who so thoroughly knows themselves and their finances as to have all their life goals completely understood.
A vendor of specific financial products is ill-equipped to provide the kind of financial planning, selection, and implementation necessary to satisfy your goals over the long haul. Without a concern for the big picture, your investments decisions will likely be shortsighted.
Just meandering in the general direction of your goal isn’t a good financial plan. Your asset allocation should be priceless.
The original version of this article was published October 30, 2006. Photo used here under Flickr Creative Commons.