As a financial planner, I am often asked how a family should invest their money. This usually means there is cash available to invest in the market and they want to know which securities (stocks, bonds, funds) to choose. Although it is tempting for me to jump into a thrilling discussion about asset classes, historical returns and low-cost options, I have learned the importance of taking a step back and starting from a place of discovery – after all, my planning philosophy is focused on ‘measuring twice.’
Investing certainly plays a major role along the path to financial independence, but there are other prudent steps to review before putting money to work in the market. Investing right away is similar to filling in the middle pieces of a jigsaw puzzle without first establishing the border. The goal of this article is to discover the frequently-overlooked areas of financial planning so we can create healthy boundaries and view our investments as a piece of a larger picture.
Assess Your Situation
The first critical step along the path is to assess your current financial landscape. You must know where you are before determining where to go (and how to get there). You can start by locating your assets and liabilities (creating a balance sheet) and reviewing how money flows in and out of your accounts (aligning your budget).
To create a balance sheet, make lists of the things you own (assets) and the things you owe (liabilities). Include details about each line item – type (cash, investment, property, credit card, loan), account ownership, location, value, loan date, and interest rate. Subtract your liabilities from your assets to determine your net worth. Since the balance sheet is a ‘snapshot’ that shows your net worth in a singular moment in time, you should update and review this financial statement quarterly to monitor your path. Over the years, your net worth should grow by increasing your assets and reducing/eliminating your liabilities.
While it can be tempting to avoid the review of your cash flows, keep in mind that budgeting is not about cutting expenses on the things you love; it is about evaluating and realigning your spending and savings with your personal values. Budgeting on purpose takes a little bit of concentrated work up front, but it makes future investment decisions more clear and less daunting. Here is a useful exercise to help align your spending with your values.
We are eager to give our hard-earned dollars a job and invest them for growth, but we should be mindful not to implement these strategies before observing and mitigating financial risks. Preparing for these risks before investing allows us to stick to our long-term plans and turn potential financial emergencies into mere inconveniences – without going further into debt!
After creating a balance sheet, you can make a plan to reduce your liabilities, since fixed debt payments can create additional stress when financial emergences arise. You may not need to be completely debt-free before investing, but you should evaluate your sources of debt and their respective characteristics to determine which should be prioritized before investing. There is an ongoing debate whether to pay off certain debts before investing, but there is thankfully not a ‘one-size-fits-all’ answer.
Each new day brings with it the possibility of sudden financial burdens, which may include unexpected events such as job loss, medical treatment, property repairs, disability, and even premature death. When the risks of loss are of low frequency but high financial severity, they may be transferred using traditional insurance. Examples include life, disability, liability, and homeowners insurance. When the risks of loss are of low frequency and low financial severity, these can be appropriately self-insured by earmarking savings in an emergency fund. Financial emergencies each have their own time horizon and risk capacity, so these funds should be invested accordingly.
Bonus: Also carefully review your insurance deductibles. If you have a healthy cash reserve, it may be appropriate to increase your deductibles to lower your policy premiums. The opposite may apply if you have not built up an adequate emergency fund.
Review Account Titling
We set up our accounts with a primary focus on the investments themselves, but should also consider how they would be directed to our heirs in the event of death. It is not a pleasant topic, but something we should not ignore.
Along with beneficiary designations on retirement accounts and insurance policies, the appropriate titling of property can also assist in the transfer of assets upon death. A last will and testament (will) is an estate planning document that directs your property to heirs through a public probate process (among other provisions), but intentionally titling your accounts can supersede this direction. For example, if you titled an account as ‘Joint Tenancy with Right of Survivorship (JTWROS)’ with your spouse listed as joint owner, he or she would receive sole account ownership upon your death, separate from the will’s direction. Inherited investment accounts may also receive tax advantages such as a ‘step-up in cost basis.’ This concept along with a comprehensive list of account types and titles are included in my previous estate planning article.
Determine Your Investment Time Horizon
“How long until you will need this money?” When we are reviewing our accounts and deciding which investments to purchase, it is essential to align the investments’ attributes with the money’s intended liquidity and time horizon. Like Stephen Covey’s second habit, ‘begin with the end in mind‘ when choosing your investments and their respective account types. Money intended to cover living expenses decades from now may be appropriately invested for long-term growth in a tax-deferred retirement account, whereas next year’s down payment for a new house may be kept in cash or invested for short-term stability in a taxable brokerage account. Giving each dollar a due date can provide useful hints as to how your money should be invested, eliminating some of the guesswork given the multitude of options.
Consider Asset Location
When developing strategies for our disciplined savings, we often focus on the investments themselves – how well they perform, how much income they pay, and how much they cost. While these are necessary considerations, aligning the tax characteristics of your investment vehicles (account types) with appropriate underlying investments can make your investment experience more intentional and less costly in the long run.
Tax-deferred retirement accounts such as IRAs and 401(k)s offer the advantage of not owing taxes on investment dividends, interest, and realized earnings along the way, but are only considered for taxation when money is finally distributed from the accounts. This means you can sell your investments within the accounts at a gain with no tax consequences, but also sell at a loss with no tax advantages. Likewise, qualified dividends within these accounts do not receive favorable capital gains tax treatment as you could in a taxable brokerage account. A thorough explanation of the investment vehicles and their appropriate passengers is available here.
Considering these steps should provide additional clarity and peace of mind when making future investment decisions. I hope you are able to establish a holistic approach for your financial independence journey, translating complex concepts into a simple actionable plan. When uncertainty arises, do not hesitate to seek additional resources or ask questions.