Set Your Goals and Check Your Risk Before Investing

Determine your goals and financial status before investing.

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Daniel Solin
Daniel Solin

You’ve probably heard the saying, “You can’t get to a destination without a map.” While maps have largely been replaced by GPS devices, the point is still the same. You need a plan.

I am struck by how few investors have an investment plan in place. Instead, they are focused on picking stocks and mutual funds and timing the market. This is a classic example of putting the cart before the horse. If you want to invest intelligently and responsibly, here’s a process you should consider:

Determine your goals. The goal of having sufficient income in retirement is very different from the goal of saving enough money to buy a home. Over the years, I have noted a wide diversity of goals of my clients. They include providing for a special-needs child, leaving an inheritance to their children, funding their grandchildren’s (or great-grandchildren’s) education and leaving funds to a favorite charity. The investment strategy for each of these goals will be different.

Be realistic about risk. Risk is a double-edged sword. On the positive side, in a properly constructed portfolio, higher risk means higher expected returns. It also means more volatility over shorter periods of time, however. Sometimes investors tell me they want returns but they can’t tolerate any risk. I tell them they don’t need an advisor and they should invest in short-term Treasury bills or an FDIC-insured savings account. Their return will be the “risk-free” rate of return, which is currently very low.

You need to understand your need and willingness to take risk and your ability to do so. These are each different issues.

I once asked an investor with a very significant portfolio why he was so heavily weighted in stocks. He told me he wanted higher returns. I asked him what he would do with the additional money if he achieved them. He had no answer because he couldn’t possibly spend the money he had already accumulated. He had no need to take such a high level of risk. If you are not as fortunate (and most of us aren’t), you probably need to take some risk to achieve your rate-of-return objective. Unless you know this objective, you can’t determine your risk.

Some investors can’t tolerate the gut-wrenching downturns in the market like the one we experienced in the recent Great Recession. If you are one of them, recognize your emotional limitations and construct your portfolio to limit your risk to a level consistent with your tolerance.

A sharp decline in the value of your portfolio may cause you more economic harm than you can tolerate. There is no guarantee your losses would not continue for an extended period of time. Could you deal with those losses by postponing retirement or saving more? If not, you don’t have the ability to take that level of risk, even if you have the willingness to tolerate it.

Only after you have engaged in this thought process should you consider your investment strategy.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, “The Smartest Sales Book You’ll Ever Read,” will be published March 3, 2014.