Money Matters: Build your investment foundation
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Frequently, I'm asked whether Apple, Google or some other random stock is a good investment. The answer often frustrates. My reply is: "It depends."
What does it depend on? Either it is a good company or not - right? Not exactly.
Just like building a solid house, you have to build the foundation of your investment plan. Identifying your financial goals sets the foundation for your plan of attack.
When we begin working with a client, we run through a set of questions that helps to determine what type of investments we hold in a portfolio.
Question 1: How much cash flow do you need from your portfolio? If you need lots of annual cash flow from investments, Google, which pays no dividend, might be a horrible choice. If you need lots of cash we look to investments that routinely pay interest or dividends we can count on.
Question 2: What is your timeframe? If your kid just got accepted to Harvard and the first tuition payment is in six months, the last place we are putting the money is the stock market. Instead, we will probably recommend something boring such as a six-month CD or cash in a money market.
While it is not exciting, I don't want to be the one to break it to Junior that because we gambled with the college fund, he won't be going to Harvard.
Similarly, if we are just trying to sock away funds for "emergency" purposes, we recommend that it stay in money market or very short-term CDs. You won't earn much, but it will be there when you really need it. Again, the stock market is not appropriate for short-term needs.
When considering these issues, remember one of Warren Buffett's favorite sayings: "Investing is not like Olympic gymnastics - there are no extra points for an increased level of difficulty." The point is, keep it simple, stupid.
If a client can truly look us in the eye and commit to a long investment timeframe - such as 10 or more years - then we will consider the stock market.
Question 3: How much volatility can you withstand? This is always difficult. When the stock market is going up we are all invincible and greatly overstate our tolerance. No one wants to miss the party.
However, when the stock market dips our long-term goals often quickly turn to short-term panic as we emotionally run for the door. If you don't know what your goals are, it is easy to do - just ask anyone who sold in March 2009.
During the past 50 years, the stock market has in one year gained as much as 56 percent, and lost as much as 37 percent. That is a huge swing from one year to the next and helps to exemplify just how volatile the market can be during short periods of time.
However, if you look at the same 50-year timeframe, but look at five-year rolling averages instead, you start to get a different picture. The best five-year rolling average return is 27 percent and the worst five-year return is a loss of only 3 percent.
Obviously, time is your friend when investing in the stock market.
Only once you have answered these questions, can you begin to consider whether or not a particular investment makes sense for you.
Dave Sather is a Victoria Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.