Welcome to my blog where I discuss money, investing, politics, and anything else import in the world. I find it surprising that most people in their 30s have very little knowledge or interest in these areas. Of course everyone is interested in money, but very few take the time or have the discipline to properly save and invest it for the future or short term. For those who at least have the interest, I'll write about my experiences and methods of investing, and hopefully give you a head start in investing.

Sunday, February 10, 2008

Investing for the Short and Long Term

Please be sure to first read my previous post "Are you ready to begin investing?". If you have determined that you are ready to invest, then keep reading. When putting together an investment plan you need to initially consider two things: (1) when do you need to use the money, (2) and how much money will you need. This determines your risk tolerance and volatility tolerance, as well as how much you should be contributing.

If you are planning to have a major purchase soon, using your investment money in the next 1-4 years, then your tolerance for volatility is low. Long term investment goals for 5 years or greater have a higher tolerance for volatility. I recommend splitting your investments between the two different goals.

For short term purchases and emergency funds, establish a high yield money market fund. Using something like ING Direct, Vanguard Prime Money Market Fund, or something similar. "High Yield" for a money market as of February 2008 is considered to be around 4.1%. Look for low expense ratios in the fund, less then 0.5%. I personally use Vanguard's Prime Money Market Fund. This is where you can keep your money liquid and safe, while still earning some return. If you don't need to keep the money liquid you may also consider a CD for a higher yield, however right now CDs are yielding less than money markets as interest rates are expected to continue to fall.

Long term investments for things like retirement and college should be allocated in a diverse portfolio with higher volatility. I do not consider retirement to ever be a short term investment, therefore it should always have a volatile component. Even if you are 64 and plan to retire at age 65, retirement is not a single "purchase" and needs to continue for another 20 or more years. Therefore, it is a long term investment.

Risk vs. Volatility
Often, people are interested in low-risk, high returns, and guarantees. Unfortunately it is impossible to accomplish all simulaneously. I prefer to look at risk and volatility separately. I define here volatility as the change in returns from year to year. While risk is the chance of not meeting your goal. Having low volatility is not necessarily good, as it still may be risky. Most important is the expected return over the long term, as a longer time horizon will smooth out the volatility and lower your risk. Generally, equities are considered to be more volatile, with bonds and CDs much less. However, there may be a greater risk that you cannot meet your goals using bonds and CDs, than with equities.

Determine Your Goal
Whether investing for a car, retiremement, or college, you need to know your end goal for funds. Sometimes, the cost will drive your purchase date, and sometimes the purchase date will drive your monthly contribution. Either way, determine how much you will need and plan how to get there. There are numerous online tools to calculate this such as savingforcollege.com and retirement calculators. They also can help with things such as asset allocation to meet your goals.
For long term investments, a combination of bonds and equities will likely be necessary to meet your target goal, to provide you with adequate return. As equities, have historically provided the greatest return and volatility, these should be used increasingly as your time horizon is long. As you approach your goal amount, shifting your allocation to all bonds or other fixed incomes is advisable.

My Allocation
I have employed for a few years now a simple formula for splitting these investments. First, as mentioned in another posting, I fully fund all retirement accounts. I then take was is left at the end of each pay period and evenly divide it between a money market fund (where I already have a $15k emergency fund) and my equity mutual funds. I use the money market fund for my short term goals, which have included a new kitchen, bathroom, and car. There is always some major purchase I am saving for, but if there wasn't, then I would increase the amount I put in my equity funds. I am currently saving for a new (used) car that I know I will need in the July timeframe. In my retirement account I invest almost 100% in equities, as retirement is at least 32 years away for me. I plan to shift to about 75/25 when 10 years away, 65/35 when 5 years away, and 50/50 when in retirement. The goal is continue to earn an annual income of 6-7% while in retirement to support a 4% distribution and 3% annual inflation. You can see my investment goals here.

My asset allocation in equities is done almost entirely with index funds and I passively manage them, only rebalancing yearly. I'll get into more detail about my asset allocation in another post, but I'll summarize by saying I like a small number of highly diversified funds. We've seen many sectors, such as emerging markets, real estate, large caps, and international funds take turns as the market leaders and I believe in owning them all.

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