Don't Ask How to Invest, Ask Why You Do

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Over the past several years, I've had the opportunity to be one of the "talking heads" that fill business television shows. My favorite question goes something like, "What's the best investment you can make today." My annoying response is that if today is your investment horizon, you'd better keep the money in your pocket, certainly no farther away than the nearest mattress. If the question is really about what you can do today to increase the probability that the money you now have will buy you more in the future than it can today, then the answer is a little more complicated. But that answer still won't be a hot stock or a sexy alternative investment or a high-yielding bond. It'll actually sound more like a college application essay.

Remember the college essay prompt that asked you to write page 175 of your 500-page autobiography? I didn't answer that one either, but before they start deciding which investments they want to make, investors should start with what plans, hopes and fears may be on four or five of those pages yet to be written about their futures. Making the most of an investment portfolio has to start with your own obligations, expectations, and dreams, because investments aren't good or bad all by themselves; I believe they are good or bad because they succeed or fail to provide you with the wherewithal to spend or give away the proceeds sometime in the future.

The first step, in other words, in figuring out what to invest in is figuring out what you want the money for, when you want it, and the degree of certainty you'd like in knowing it won't disappear. That will take some work. Many of us have sat down and listed the major costs we expect we'll need to fund in the future. If not, it's time to do so; if you have such a list, it couldn't hurt to review it. We know the major items: college tuition, a secure retirement, periodic vacations, maybe a second home, and, of course, a reserve fund for emergencies. Life would be much less interesting if it were possible for such a list to be certain and static, but without it how can we possibly know how much we do need to put under the mattress and how much can be put at greater risk in the hope of achieving a financial goal that's currently out of reach?

A careful focus on risk follows from the process of writing those pages of your eventual autobiography. Many attempts to give you investment advice begin by asking you what your risk tolerance is. That's a useless question. Why? Because your risk tolerance for making next week's rent payment or meeting a tuition bill is surely much lower than your risk tolerance for one day buying a yacht. We often think of risk as the danger that an investment we make today will go down in market value tomorrow, but if we've built a hierarchy of eventual spending plans, that view of risk becomes much more nuanced. The real risk is that the value won't be adequate at some approximate time in the future. The difference is very real. Here's why:

According to the Investment Company Institute, since 2007 U.S. households have responded to worrying financial headlines by consistently taking money out of their equity-based mutual fund portfolios and adding to their fixed income funds, especially fixed income funds that invest in government-related bonds. Investors I talk to tell me that they've steered their funds this way because they worry more about "return of principal" than about "return on principal." They've wanted to reduce risk, but in my opinion what they've really done is reduce risk in the short term in exchange for taking considerable additional risk in the long term.

Let's say that a "safe" fixed income investment offers the yield of the U.S. 10-year treasury, which as of this writing is something like 1.80 percent per year. That yield will be considerably less for shorter-term bonds, money funds, and most kinds of bank deposits, and possibly higher if it includes bonds from government entities tied to the mortgage market. If inflation continues to rise from its most recently measured annual rate of 1.7 percent just to the Federal Reserve's targeted rated of 2 percent, investors whose fixed income funds yield 1.85 percent or less will simply lose purchasing power every day they hold onto that investment.

Here's where timing your spending plans comes into play. If all you hold in that government-related bond fund is the money you expect to need in the next year or so, your risk of losing purchasing power is fairly low and it's a fair price to pay for the solidity of the underlying investment. If, however, that's money you plan to use for a college tuition payment, your retirement, or eventual health care costs some years from now, the risk of declining purchasing power looms much larger.

Recent Federal Reserve and European Central Bank policy initiatives to avoid economic downturns and the potential for deflation reinforce the need to protect purchasing power. Perhaps most importantly, Chinese central planners' determination to reorient their vast economy from flooding the developed world with inexpensive manufactured goods and toward increased domestic demand may mean that U.S. consumers may not permanently be able to import disinflation from abroad.

So please don't ask me what my single best investment idea is. Tell me how you intend to spend your investment proceeds, how soon you're likely to spend them, and what the consequences of financial reality falling short of your expectations might be. Then we can talk.

Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.



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