Investing has a major role in financial planning. This is due to our reliance on investments to increase our wealth and assist us in reaching our financial goals. Despite the importance of investing in our financial plans, many people are hesitant about investing as they are unsure about where to start. Like financial planning, investing also has a logical and systematic process for successful implementation. Using a defined process when tackling complicated tasks helps us keep our focus and improves our chances of success. The following illustration of the investment decision making process has been simplified, however it provides a great foundation for starting your quest for investing knowledge.
Budgeting, Cash-flow and Capital Needs
In the beginning of the investing cycle, you should begin by determining how much you can and need to invest. To calculate how much you can afford to invest you will need to build a budget and analyze your cash-flows. Your budget will assist in determining how much income you have left over after expenses. This amount will be how much you can afford to invest.
In addition to calculating how much you can invest, it’s wise to determine how much capital you will need in the future. I will leave the instructions on how to accomplish this for another post. However, you can still start to create a simple estimate on how much you will need to retire and make a list of your other future expenses.
Determine the Right Asset Allocation
Asset allocation is the process of deciding how much of your capital to invest into the different categories of investments, such as stocks, bonds and cash. The right asset allocation strategy for your situation is heavily dependent on the amount that you can invest and your future capital needs. Your asset allocation should also take your risk tolerance into consideration.
In the most likely scenario, if you do not have enough capital to invest based on your future needs you will have to allocate more resources to high risk/ high reward investments. On the other hand, if you have a higher savings rate you should be able to reduce your exposure to risker assets.
Selecting Financial Instruments
Once you have determined the right asset allocation strategy for your situation, you will then get the opportunity to choose individual bonds, equities, mutual funds and other financial instruments for your portfolio. The types and amounts of the assets that you buy should be based on your asset allocation strategy.
When selecting which stocks and bonds to invest in there are a few critical criteria that you should consider. First, always research and understand what you are investing in. Second, timing your transactions can make or break an portfolio; carefully plan when you buy and sell securities. Finally, pay attention to global economics and the business cycle as it could save you a lot of money and frustration.
Please keep in mind that this is a very high level illustration of the investment decision making process. Investing can become a complicated endeavor, however sticking to these fundamentals will help you simplify it to the bare essentials.