By Dwayne Grady, Vice President, Goldman Sachs Personal Financial Management
Every so often I get a new client who’s eager to start investing. Sometimes, maybe a little too eager. Because as we talk, they inevitably mention being interested in a handful of companies. A lot of the time they’re talking about “hot stocks” that were once just a few dollars a share and are now trading for astronomically high prices.
I do understand the appeal of such stocks. The thought of potentially turning a small investment into a small fortune with little effort is quite appealing. But looking at a stock that’s risen sharply in a short time and expecting any one of hundreds of other stocks to repeat that lightning strike is fraught with risk. And it’s not a long-term investing strategy. It’s gambling.
Being invested in stocks like that at just the right moment is far more complicated than it seems. Successfully trading such a stock takes a lot of luck and impeccable timing, both of which are impossible to predict.
And while it might have worked out for your brother-in-law or your neighbor down the street, let’s be honest that hindsight is always 20/20. You’re looking back at a dramatic price increase in a stock that was far from inevitable before it began.
But those handful of companies get an awful lot of attention. And I know people want to get on with the fun part of investing – watching their investments increase in value. But there’s work to be done first. You have to establish a foundation.
I call that foundation the “four cornerstones” of financial planning.
Think about a cornerstone for a moment. When a building is under construction, the first stone laid down is called the cornerstone. It’s a critical part of the building, the foundation that the entire structure rests on.
Just as in construction, you need cornerstones when building a financial plan. I believe the key to putting any plan on solid footing means starting with a foundation that consists of four cornerstones: cash reserves, insurance, equity assets, and fixed assets. The first two are the ones you live by. While the last two are those you grow by. Let’s take a look at them.
I like to refer to these first two cornerstones as the ones you “live by” because they’re part of your everyday finances. These are the basic building blocks that should be in place before you do anything else.
The first is your cash reserves, having enough money set aside to cover all your living expenses for a minimum of three months. Preferably six months. The second is insurance (or risk management) to protect what you’re building.
Cash reserves. This first cornerstone is the most important. Cash reserves are used to protect you in the event of an emergency or to take advantage of an investing opportunity. Your reserves should be sufficient to cover your fixed expenses for a minimum of three months. And what are fixed expenses? They include any expenses you must pay every month – rent or mortgage, car payment, utilities, and groceries. Ideally, you should have enough to cover six months, but you can start with three.
When you’re ready to start building your cash reserves, you might consider thinking of it in tiers, using different financial vehicles:
Insurance (risk management). While it might sound difficult or intimidating to “manage risk,” it really just means protecting yourself from the unexpected. In this case, protecting your finances from the unexpected means insurance. The key, of course, is to get the proper type of insurance, and the right amount of coverage. Too little, and you’re not protected. Too much, and you’re spending money you could use elsewhere
The amount and type of coverage you need will depend on your unique financial circumstances and goals – and we encourage you to reach out to your insurance specialist to tailor coverage to your needs. But for now, let’s break down at a high level the types of insurance you may need.
With your first two cornerstones in place, you can turn to the remaining two – the cornerstones you’ll grow by. The first of these cornerstone is equity assets, basically ownership of an asset, including stocks and real estate. The second is fixed assets, what I like to call “lendership,” including government, municipal, and corporate bonds.
An advisor who understands your overall goals, time frame, and risk tolerance can help devise a diversified portfolio of equity and fixed assets to meet your needs. Let’s take a closer look at each of these cornerstones.
Equity Assets. Here I’m talking about assets that you own. These are long-term investments such as stocks, mutual funds, ETFs, and real estate. Owning these assets means taking on some amount of risk because of their ups and downs over time. For that reason, I personally believe you should ideally hold them for a minimum of five years in order to realize a gain sufficient to make up for that risk. As a general rule, a diversified asset allocation could include a mix of large, mid, and small cap stocks, as well as international equities.
Fixed Assets. This is the final cornerstone. Here, I’m talking about bonds. When you buy a bond, you agree to lend money to a corporation, municipality, or government in exchange for the promise of being paid back interest over time, as well as your principal when the bond matures.
Bonds typically don’t come with the same level of risk as equity assets, so they can help add some stability to your portfolio. Because bonds also provide a regular or “fixed” rate of return, they’re also well-suited to meet shorter-term term goals of less than 5 years. But, of course, a good advisor can recommend a diversified asset allocation of fixed assets to complement any equity assets you may hold.
So there you have it, my four cornerstones designed to provide a solid foundation for your personal financial plan. For many people, I’ve found that the toughest thing about putting the cornerstones in place is simply getting started. If you can get past that inertia, I think you’ll find it’s comparatively easy to stay with it - because you have a destination in mind, and you just need to keep moving toward it.
And that brings me to my final point. There’s one last component of any plan that I haven’t mentioned, and it’s a big one. Time. The earlier you put your cornerstones in place, the more time you give your investments to grow. It’s so important, in fact, that it can sometimes be possible to invest less and end up with more simply by starting earlier. But that’s a topic for another time.
So, are you ready to get started?
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