Align Your Investment with Your Life Style
Stocks, bonds, currency, real estate, private funds
by Sharleen Yuan
We all know how wonderful it would be to have financial freedom and retirement by the age of 40s, the key question to ask is how to achieve that. Being flooded with liquid investment options such as CDs, stocks, derivatives, bonds, mutual funds, as well as illiquid investment options such as real estate, private funds, how should we deploy cash to optimize our returns? People with various risk tolerance level would have different answers, yet asking the following questions to yourself can help reach an answer that fits your unique financial situation.
What’s considered financial freedom for you?
The alternative way of asking is - what kind of lifestyle do you envision? For example, how many times do you want to travel with your family each year? How much time do you want to spend with your children and do you want to work part-time or full-time? Do you want to be fully responsible for your children’s college tuition? Where do you want to live - west, south, east, north, cities or suburbs? After reflecting upon these questions, the starting point would be to look at your monthly expenses regardless which stage of life you are at, or your employment status. Ask this to yourself - after tax, how much do I need to cover mortgage/rent, utilities, child care, restaurants, groceries, shopping, travel, entertainment expenses, and how much should I save for investments, education, and emergency.
It may sound daunting. But it is much easier to do than you thought. Leveraging some tools can minimize the pain. I find Mint.com a great tool that allows you to synchronize all your credit cards in one portal to monitor monthly expenses. The app helps you categorize these expenses and alert you when you are overspending.
After monitoring and analyzing your spending habits for a few months, you will have a better understanding on your savings rate, and whether you want to reduce certain unnecessary spending.
What’s my current portfolio composition?
Believe or not, a good asset allocation means you are 80% on your way to financial success. Broadly speaking, there are three types of assets: fixed income, equity, and a hybrid of both. Fixed income refers to assets that generate determined monthly/quarterly/yearly cash flows while offering no appreciation at maturity, i.e. bonds. Stocks, on the other hands, provide no predetermined cash flows, but have appreciation potential. The combination of the two could be real estate, REITs, preferred stocks, where you receive scheduled income and appreciation at sale. Here are some vehicles that you may are already familiar with that carry these investments:
According to JPMorgan, REITs (Real Estate Investment Trust) generate the highest return (9.9%) than other asset classes in the past two decades , while stocks (S&P 500) return sits at 5.6%. Investing in either of the asset classes requires reasonable expectations on risks, returns, and investment horizon. Most importantly, your experience and expertise count, and the advisor/team you work with are crucial to your financial success.
What should my portfolio look like?
Everyone is familiar with the saying, "Don't put all your eggs in one basket." and “ The higher return, the higher the risk.” Besides these two principals, there are three essential numbers that guides you to determine required annual yield:
Annual savings to invest
Annual investment return
Assume the following variables:
Target annual return in dollar amount (before tax): $150,000
Annual savings for investment: $50,000
Annual investment amount: annual savings for investment + returns from existing investments in the previous year
As shown, if you are saving $50,000 each year to invest, it takes 15 years to generate $150,000 annual passive income. If you are young and have very high risk appetite, you can achieve $150,000 annual passive income in 10 years by investing into a portfolio with 15% return.
As hinted in the previous section, there is no right or wrong asset allocation to achieve target returns for individuals. Rather, liquidity, expertise, and barriers of entry should be carefully considered. Stocks, mutual funds, ETFs have very low barriers to enter and provide good liquidity, while the interim cash flow is uncertain. Real estate investments are more capital intensive, and the amount of effort/knowledge/experience determines your investment results. In turn, you are rewarded with relatively stable monthly rental cash flows.
Knowing your current financial situation can help you determine how much return you need. Understanding your investment expertise and risk appetite can facilitate the formulation of your forward asset allocation. If you
are young with stable income
care less about stable monthly cash flow returns
do not have significant amount of cash in hand
are still learning about illiquid assets such as real estate,
Then liquid assets will be your first choice, and you can slowly start to accumulate safe illiquid assets. If you
generate stable monthly cash flow in the future
have more savings to investment
understand the know-how in illiquid assets
understand the financing aspect, a.k.a leverage in investments,
Then you can position yourself for riskier but more lucrative returns.