Financial planning is important, but it is never urgent. Most people fail to establish a financial plan because they fail to start planning. Some resolutions can be postponed, but for every six years that you delay saving and investing, you cut your retirement lifestyle in half. So, act on your resolution today.
To successfully build wealth, you must know the answer to two important financial questions. However, many Americans never bother to get the answer for themselves. Being able to answer these two questions is an important first step toward meeting your financial goals.
Depending on your station in life, this first question should be modified to fit your situation. For those who are still saving for retirement the question is “How much money do I need to save this month to cover my longer-term financial needs?” If you are already retired, the question is “How much money can I spend this month so that I don’t run out of money during my lifetime?”
Don’t try and sidestep this first question by thinking you will work forever. Assuming you won’t retire is not a good retirement plan. Neither is dying young.
If you are a woman, you are much more likely to outlive your family’s finances. If you fail to save enough during your working years, your investments may not keep pace with inflation or your spending may leave you out of money.
When you run out of money during retirement, you lose your lifestyle and your independence. Knowing how much you should be saving or spending minimizes the chance that you will outlive your money and provides you with peace of mind.
The second question you should be able to answer is, “What return on investment did your assets earn last year?” If you think a couple percentage points on your investment return each year won’t make much difference, think again. Adding a few more percentage points to your return, compounded over 40 years, will double your standard of living in retirement.
It is also unwise to assume that your portfolio earned roughly the same as the indexes reported in the news. Your asset allocation will determine the majority of your investments returns. Consider the following different returns for the exact same year.
In 2000, when large cap growth stocks lost 33.51%, small cap value stocks earned 18.58%. In 2001, when the NASDAQ lost 21.05%, the Russell 2000 Value earned 14.02%. In 2002, when the S&P500 lost 22.10%, the Johannesburg Stock Exchange Gold Index earned 130.33%. In 2003, when the Lehman Aggregate Bond earned 8.44%, Emerging Markets earned 42.34%. In 2004, when the Dow earned 5.31%, the Goldman Sachs Natural resources earned 24.57%. In 2005, when the S&P500 earned 4.91%, the EAFE Foreign Index earned 25.96%. This past year, in 2006, while large cap value was earning 25.78%, large cap growth only earned 5.68%. How did your portfolio do?
If a few percentage points can double your retirement lifestyle, having a proper asset allocation is what makes it possible to retire comfortably in the first place. Until you know the exact return of your investments, you won’t be able to evaluate the drag on your portfolio by being too conservative or the cost to your portfolio by being too aggressive. You also won’t be able to evaluate the hidden costs of investments with high expense ratios or transaction fees.
David John Marotta works at Marotta Asset Management, Inc. of Charlottesville which provides fee-only financial planning and asset management.
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