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Review this guide

Taking control of your investments is a smart thing to do. Saving and investing for your future is important, maybe one of the most important things that you’ll do and leaving it up to people that don’t have the incentive to act in your best interest is maybe one of the dumbest things you can do in your life. This is your financial future and you should take control of it. With that said, many will learn some basic or even complex nuances of investing, learn how to pick stocks and ETF’s or even pick the mutual funds in your 401K. And generally I think everyone has the same basic approach of taking acceptable risk and trying to earn a high return. But I find that what people invest in is typically based on personality toward risk. Risk taking people invest in riskier assets while risk averse people will tend to stray away from riskier investments and stick their money in mostly fixed income. What few personal investors do is actually plan out what they need by creating a long-term financial plan, the plan that should be the basis for all your investment decisions.

First off, if you have the smarts and intelligence to invest for yourself, I am confident that with just a bit of effort, and some Microsoft excel acumen you have what it takes to make an intelligent long-term financial plan.

The first and potentially most complicated thing you need to do is calculate your required return. As with any investment strategy, the goal is to make sufficient return with minimum required risk. Then potentially trade some risk for some upside. But these aren't decisions that you can intelligently make if you don't have an idea of what your required return is.

Calculating your required return:

- Forecast the rest of your life. You can be as detailed as you want, but you need to build a model showing the cash flows going into and out of your savings. For those with basic excel skills, this really just needs to be a year by year cash flow of how much savings are going in and then coming out in retirement years. The more detailed you are here, the better this model will be, so think of things like increases in living expenses, paying for weddings and kids educations. Understand, that your retirement spending will be more than your current spending; as you'll either be making annual trips to Italy or paying for an in home nurse. And off course, make sure your considering inflation. For the more savvy excel users, you can model out your net worth year by year, by starting with an assumed return on your savings.
- Put your goals into your forecast. How much do you plan to leave your kids when you die? But ensure that these are your basic goals. Maybe you'd like to be able to buy a summer home in Italy when you're 60. This is a goal that you can play with your investment strategy exchanging risk for financial upside, in your model only include your must have/reasonably expect goals.
- Calculate the required return. For the basic excel user, this is just calculating the IRR for the stream of cash flows. For the savvy excel user, you are going to want to goal seek the savings return that meets your end state goals. (Most likely the inheritance amount)
- Now you're going to have to adjust for common sense. If you're required return came out to be 2%; then you're on track. You should invest close to cash, and maybe take some additional risk if there are some stretch goals that you would like to meet. Maybe go back to your model and throw in some of those stretch goals and calculate again. However, if your required return came out to 12% you may have to revisit how reasonable your basic goals are. Moreover, you have to consider the return you'll actually earn when you are retired and close to retirement. In those later years, you likely wont be willing to take the risk necessary to target a 12% return. You are more likely to be in principal protection mode, only earning 3% ish. Incorporate this into your model. For the basic excel users, select a fixed safe return and calculate the present value of your cash flow to your 50th year. Use that figure as your new ending cash flow and re-do your internal rate of return. For the savvy excel user, fix the savings return in the later years to the fixed savings rate and then redo your goal seek.

Interpreting your required return:

First things first, note that even extremely long term models are not tools to tell you what you should do in the future. You can't make future decisions today. You can only make today's decisions today. Planning is still an essential thing to do because it gives you vital information for the decisions you make today but things will not go to plan, and you should repeat this model annually.

Second, understand that the figure you got is the target return for today, but your goal isn't to get that. It's to minimize the probability that you don't. To that end, understand your time horizon. If you're required return is 4% and you're only 35 years old, buying a AA 30 year corporate bond that yields 4% is probably riskier than investing entirely in an SP500 ETF. The probability that you return on average less than 4% in equity markets over a 30 year period is lower than the chances that a AA bond defaults over 30 years.

Create the mix that minimizes your failure probability and then play the risk reward game:

However, you measure risk is fine. But do some form of math to give you a sense of your chances of success given different portfolio options. Than adjust. If you love to invest, make some realistic expectations for your "alpha" portfolio and see how much allocating to your portfolio to alpha impacts your probability of failure.

Be yourself:

If you're a risk taker, don't be scared to lower that probability a little bit for some upside, you are who you are. If you're risk averse, understand your probability of failure number. Don't invest in a manner that your certain to fail, but just by a bit. Always plan to succeed.