Good financial planning decisions extend well beyond where and how you invest. A number of important and complex decisions must be made before you buy a stock, bond, or any other type of investment. Before you do, ask yourself these seven questions to understand if you are about to make a good financial decision.
Question 1: Why Invest At All?
Before investing it is important to ensure your money is being used to best help you achieve your goals. For instance, depending on your own personal circumstances, it may make more sense to pay down existing debt before you invsest, especially if you have any high-interest debt such as a credit card. It also makes sense to build an emergency savings fund or purchase insurance before you put money into the stock market.
“Ensuring this question has been adequately answered should provide an investor with some assurance that investing makes sense for their situation and that they can develop a goals-based financial plan”, says Paul Kaplan, Morningstar’s director of research.
Question 2: What is an Appropriate Risk Level?
Creating a portfolio that is consistent with your ability as an investor to take on risk is a complicated exercise. It is important to consider not only your risk preference (how would I feel or react if the stock market dipped), as well as your risk capacity (how much risk can I afford to take given my resources and financial situation).
“Regardless of approach, though, ensuring the portfolio is consistent with the investor’s risk appetite is a very important part of the portfolio process”, says Kaplan.
Question 3: How do your Goals Affect our Portfolio?
People generally invest to fund a specific goal, such as saving for retirement. Therefore, it’s important to understand how the risks associated with the goal itself should affect the portfolio and include them in the portfolio optimisation routine.
Question 4: Which Type of Investment?
Different investments have different tax attributes and fees. Understanding how these and investing appropriately can increase an investor’s effective returns. Investors putting money into a pension, for example, enjoy tax relief on their contributions meaning you can effectively invest £1 for the price of 80p (or 60p if you're a higher rate payer). Returns made on investments in tax-free accounts such as an Isa, meanwhile, are not subject to capital gains tax. Utilising these accounts can serious boost your returns over the long-term.
Question 5: Which Asset Classes Should You Consider?
After determining the appropriate target risk level, an investor must determine how to construct a portfolio. “If the investor is targeting an overall equity allocation of 60% of assets, they must determine how to invest in equities (i.e., for a given risk level)”, Kaplan explains. “The investor could choose to invest entirely in domestic large-cap equities or create a more efficient portfolio by considering additional asset classes such as domestic small caps, international equities, emerging markets, etc”.
Question 6: Which Investments Should You Select?
Once the asset class targets have been set, the next step is to determine which specific investments to select. There are a variety of potential investment vehicles to choose from, such as mutual funds, ETFs and investment trusts, as well as individual shares and deciding whether to take an active or passive approach. Given the relative difficulty of consistently selecting funds that outperform peers on a risk-adjusted basis, investors should focus on keeping costs down and have a proven system when selecting active managers.
Question 7: How Frequently to Check Your Portfolio?
Revisiting your portfolio is important and ensures your investments stay in line with the underlying goals and objectives of the investor. But investors should avoid checking in too often as it's easy to be spooked by short-term dips in performance or tempted to tinker with your holdings. “At a minimum, assuming the investor’s goals and objectives have not changed, the portfolio should be rebalanced at least annually”, says Kaplan.
