Investment capital is deployed with the expectation it will earn a positive return. Equity investors expect their money to grow. If returns compound for many years, funds may multiply in value. Bond investors seek more modest returns, a fixed income equal to a percentage of invested capital and the eventual return of their investment. In some cases, investing means foregoing current consumption desires in favor of important future financial outcomes. In this context, growing assets or collecting income is a means to a more important end. For many individual investors the reason to invest is to finance specific future consumption goals.
Investing in the Context of Consumption Goals
Defining investments in an academic or business sense uses the language of mathematics, statistics, and economics to explain how a given asset performs or how its performance compares to other assets. Typically, these definitions are technical and dry. They are precise and resonate very well with business students and investment professionals.
And while absolute and relative investment performance are certainly import metrics for individual investors, they may miss the relevant points about why you should invest.
The reasons people should invest are all around them. You should invest because:
- Your kids may go to college
- You may pay for a child’s wedding
- Your family loves vacations
- You want a new car every five years
- You want a bigger home
- You want to retire at a specific age
- Of every other imaginable goal you might have
So, a critical part of the investment process is understanding what you’re investing for in the first place. When you know this, you’ll be better able to match to your investments to your goals.
Compound Returns and Future Goals
The math behind compound investment returns – the process of continually earning a return on growing balances because previous balances earned a return – is less important than what it can accomplish for you.
Investing is the process of making your financial resources work for you. When you invest, you’re financing your long-term goals. Your investments are, in essence, your employees working to help you reach those goals.
Some of your investments may grow over time in a way that might allow you to purchase more in the future than those dollars could buy today.
Compounding returns can make those dollars – your workforce – multiply over time. The more dollars you have working for you, the more dollars they may create for you. If this happens over a long period of time, you may stand a reasonable chance of achieving your high priority future consumption goals.
But investments aren’t predictable.
How Volatility and Risk Tolerance Impact Your Goals
All investments fluctuate in value. The range of that fluctuation and the expected return of a given investment are not very predictable in the short run. But historical observations of different investment types suggest some predictability about the range of risk and potential expected return they might offer long-term investors.
In general, history suggests that riskier assets provide higher rates of return than less risky assets. Said another way, a willingness to accept more risk may lead to higher investment returns. Conversely, avoiding risky investments may lower your investment returns.
Your willingness to accept fluctuations in investment value (i.e., risk) in exchange for the expected return suggested by those historical observations defines your risk tolerance.
Establishing specific goals gives you a target to aim for. Those goals define how much money you’ll need (and when you’ll need it) to finance them. From here, you work backward. Here are the steps:
- Take what you need to have
- Subtract what you have today
- Subtract your expected capital contributions
- The difference is the gap you need to fill
This gap tells you how hard your money needs to work for you to achieve your goals. So, in a sense, your goals determine the composition of your investments.
If the gap suggests that your investments would stand a good chance of helping you achieve your goals even if they earn a modest rate of return, then you may be able to finance them with lower-returning (and perhaps less risky) investments.
If the gap suggests that your money will have to work harder to adequately finance your goals, then you may have to take on more risk. If additional risk is acceptable to you, then you may be okay. If it isn’t, then you may have to rethink your plans. Some of your options include:
- Curtailing current spending
- Increasing current saving and investment
- Working later in life
- Postponing certain future consumption goals
- Foregoing certain future consumption goals
Since the whole point of investing is to help you achieve specific goals, it is important to plan ahead early to make sure your goals are attainable given your resources and your risk tolerance.
Don’t Lose Sight of Your Goals as Circumstances Change
Change is inevitable. Markets change, economies change, even your goals and objectives may change.
So, it may become necessary to adjust plans as changes occur over time. Monitoring and adjusting allows you to make changes to stay on track.
This means that periodically rebalancing your portfolio may be appropriate. A wholesale change in asset allocation isn’t necessary unless something significant changes in your life. But making sure the original allocation remains within a narrow range may be prudent. It may also help keep your overall returns close to the level necessary to achieve your financial goals.
Follow a process to achieve long-term goals can put you in a position where you won’t be tempted to react to day-to-day market movement, news headlines, or the latest investment fad.
Creating Positive Outcomes
Nothing in the future is certain. Investing doesn’t change that. But it may help you maintain a little more control over how your future consumption goals will be financed. Using a goals-based approach can make the process more relatable, more understandable.
Considering your investments in the context of how they may help you reach the positive outcomes you desire may also remove some of the unease that comes with periodic market fluctuations. The key takeaway should be that you’re not investing for investment’s sake. You’re investing for all of the consumption goals you want to achieve.
Use our Retirement Nestegg Calculator to measure your progress toward achieving your high priority goals!