A lot of times when an individual starts talking with a financial advisor, they have a certain investing idea or goal in mind – such as starting a Roth IRA, rolling over a 401k, or saving for their kids’ future college costs. Other times they want a specific investment idea – such as which mutual fund company to invest in or how much to have allocated in the United States market vs overseas.
I believe – in theory and in practice – that it is be difficult to know the How (type of account) and What (specific investments) to invest in without first knowing the Why to invest, which is the reason I place such a large emphasis on financial planning first, and investing second.
Each one of us has a finite amount of wealth, whether we measure that by our income or assets, and an infinite amount of options how to use that wealth. This is the very definition of financial planning: the ongoing allocation of limited resources towards unlimited opportunities. When making investing decisions, it’s crucial to evaluate Why we want to invest, because knowing the answer to the Why helps set the context and eventual direction for the How and What. Here are a few examples of cases I’ve seen when working with clients.
Example #1 Time
A young couple has a goal of saving 20% for a down payment on their first house and envisions wanting to buy that house in the next 2-3 years, it makes little sense to invest that money in the stock market because there’s a possibility the money could be worth less when the time comes to make their offer on the house, due to the inherent volatility of such investments. It makes more sense to park those funds in a savings account or maybe a bond-fund, even if the rate of return is considerably lower. If, however, that same couple wants to invest for their future retirement, then creating a portfolio that includes stock market exposure can make sense because even with the volatility, there is a higher chance of getting a higher rate of return on those funds. Understanding the Why – the time frame – helped guide the What – not being invested in the stock market.
Example #2 Flexibility
Two parents wants to start saving for their kids’ future, initially thinking a 529 Plan makes the most sense because it’s what they have heard about before. However, they aren’t 100% sure that their kids will want to attend college, and want to give their kids some flexibility and options on how those funds are used when they are older, such as a down payment on a house, a wedding, or starting a business. If they had saved by default into the 529 Plan, they would be facing some penalties and tax ramifications if money was used from the 529 Plan for something other than higher education. Understanding the Why – the desire for flexibility – helped guide the How – investing in something outside of a 529 Plan.
Example #3 Age
A 19 year old, completing a trade-school program, is entering the work force with zero debt. The financial rule of thumb to save 10-15% of his income in retirement puts him lightyears ahead of his retirement projection, and he doesn’t have an early retirement goal. We ran some calculations, and with 4+ decades of compounded growth decided he wouldn’t need to do the full 15% of his income into retirement savings, and instead invest/save towards a down payment and some other shorter-term goals. On the flipside, a couple in their 50’s hasn’t accumulated much retirement savings, and would like to retire within the next 10 years. With such a relative smaller time frame before needing the money and compounding not having its long of a runway, we need to make up the shortfall with more dollars invested, much more than the rule of thumb. Understanding the Why – the age of the clients – helped guide the How – as in the amount of money that should be saved.
Another point worth noting here is that the initial Why might change – in fact, in most likelihood it will change. And that’s absolutely fine, and to be expected. The key is to make sure the How and What of your investments is dynamic enough to evolve with those changes.
Additionally, there is also the very real possibility of getting stuck in the Why, an analysis paralysis of sorts, and never moving into the How and What. This is perhaps even more detrimental. The best approach is to create a plan that addresses the Why, even if it’s not perfect, so we can move into the How and What, and simply adapt the as life happens.
Traditional financial advice goes something like this:
What > How > Why
Real financial advice goes something like this:
Why > How > What
There’s a big difference.
*Image credit to Behavior Gap.