IN BLACK AND WHITE

 

Framework for financial success


I am frequently approached by people as a sounding board for some new investment “opportunity”. I get asked about subjects like binary options trading, foreign exchange trading, penny stocks that are yet to be listed and various other schemes that promise returns which dwarf those typically available from even the best performing traditional investment sources.

Most of the time these alternative investment “opportunities” are frustrating simply because they are riddled with all the usual warning signs that make them speculative gambles at best and probable fraudulent schemes at the other end of the spectrum.

A common thread is always the promise of quick riches. Usually the source of these high returns is some black box methodology that no one else has come up with before.

Match your goals to appropriate investments - White Investments

When assessing these opportunities I don’t think you need to be an investment expert. You can apply a simple common sense test that usually saves you a lot of time (and ultimately money) – “If I had an idea or a trading system that delivered super-normal profits overnight without taking any risks would I share it with the world (for a price) or would I just milk the system and live out my days in paradise?”

Understanding the source of the advice you receive and understanding how the advice provider is being remunerated is another useful distinction to make when assessing investment opportunities.

For example, I get paid the same for the investment advice or discretionary management service that I provide, regardless of the products I use or indeed where I decide to place the funds. In my attempt to make a real difference, I provide a service that I think will offer the best chance for a client to achieve their stated objectives, with the greatest degree of certainty.

If I thought any of the ideas or schemes that promote fast profits were genuinely worth pursuing or likely to be credible I would get involved but most of the time investing towards long-term goals is not an exciting, white knuckle ride.

There is a basic framework that I have created to provide clients with an indication of the types of investments I think they should consider, and when they should consider using them, to create risk appropriate investment solutions for their life and investment goals.

Framework for Financial Success

Level 1: The Basics (Primary Goals)

These are in my mind investment objectives that should be prioritised as they have a direct impact on your long-term financial well being.

The key thing about the objectives at this level is that if you were to fail at any of them it would have a direct, tangible, negative impact on your financial well being and that of your dependents and loved ones.

Since the severity of failure here is hardly worth considering I suggest we use investments which actively seek out to maximise the certainty of success as far as possible while at the same time minimising the opportunity for poor financial outcomes.

Examples of Level 1 objectives include:

  • Retirement planning – pre and post retirement
  • Education planning
  • Primary Residential Housing
  • Rainy day or emergency funds

Types of Level 1 investments:

  • Collective Investments(Unit Trusts & Exchange Traded Funds),
  • Bank and money market accounts,
  • RSA Retail Bonds

I would argue that buy to let property portfolios are probably too concentrated and illiquid to comfortably fit into this level but I know of a few property bulls that would disagree.

Characteristics of the Level 1 Strategy:

  • Exclusively invested in listed securities – Easy to access relevant investment information, valuations are readily ascertainable, you have reasonable ability to research the options and make informed decisions and you receive regular and detailed statements, including reports on how these investments are performing.
  • Typically adopts a Balanced Approach – Diversify asset classes strategically and tactically. Asset Allocation is optimised to achieve targeted returns in a risk efficient manner.
  • Reasonable certainty about the returns you would expect to receive and how your portfolio would behave through the investment cycle.
  • Makes full use of tax free accounts, tax deferred accounts (Retirement) and other tax saving allowances.
  • Low levels of concentration to any specific single company or sector relative to benchmark.
  • Passive funds dominate.

Outcomes achieved by a Level 1 Strategy:

A well diversified investment portfolio that can attempt to optimise required returns against appropriate risk parameters.

Virtually fully indemnifies a portfolio from any probability of a permanent loss of capital.

Passive investments will minimise costs. Low costs will mean more of your contributions and compounded returns filter through towards your investment goals.

Should require less trading as portfolio is only tactically adjusted and strategically rebalanced.

The Level 1 portfolio should be highly tax efficient.

Goals are specific, measureable and prioritised.

I would say approximately 90% of the public will fall into this category alone. 

Level 2: Lifestyle (Secondary Objectives)

This is the level which captures your wants rather than your needs in life. Failure to meet these objectives will not de-rail your overall financial plan.

Since Level 2 objectives are likely to involve goals that you would consider less of a priority and more out of reach, you will probably require higher returns if you are to achieve them. You may therefore be more willing and able to assume greater risk in pursuit of these goals.

You will almost certainly be required to take on more risk to achieve the returns you will need to reach your lifestyle goals.

Examples of Level 2 objectives include:

  • Holiday Homes
  • Dream Car
  • Hobbies
  • Overseas holidays
  • Bigger home
  • Charity

Types of Level 2 investments:

  • Direct share portfolios – high levels of concentration to specific companies
  • Sector specific bets – resources, financials, industrials
  • Small caps
  • Commodities
  • Private Equity Funds & Venture Capital Funds (May be more illiquid – “lock-ins”)
  • Active funds where you believe the managers have a superior ability to deliver performance.
  • Buy to let properties may fit in here in terms of concentration risk and illiquidity but whether they will provide the higher required returns to reach your goals is another matter.

Characteristics of the Level 2 Strategy:

  • Higher degree of fluctuations in the value of portfolio.
  • Less diversification as a result of concentrated positions.
  • Shorter investment time horizons
  • Likely to involve a higher level of trading activity.
  • Investments should still be restricted to listed securities.
  • Less ability to utilise tax efficient vehicles.
  • Accessing these investments is likely to be more costly than those at Level 1.

Outcomes achieved by a Level 2 Strategy:

Increased possibility of higher excess returns.

Greater position concentration will increase the chance for a permanent loss of capital.

Costs will be higher to access either active or specialist funds as well as the increased costs associated with greater trading activity.

Likely to be less tax efficient – trading and shorter term focus.

Goals are still specific and measureable although the certainty of attaining them is diminished by the need to assume more risk to try and make them a reality.

I would say approximately 99% of the public will fall into a combination of Level 1 & 2 strategies.

 

Level 3: Looking for a little magic

This would include investment allocations to things that could significantly increase your long-term wealth but also have a very high probability of outright failure.

Examples of Level 3 objectives include:

  • Intergenerational wealth creation
  • Philanthropic endeavours
  • Research
  • Changing the world

Types of Level 3 investments:

  • Unlisted equity investments – Trying to pick Google or Apple at the founding stage.
  • Funding at the pioneering stage for unproven innovations and ideas
  • Incubation funding for start-ups (Angel capital)
  • Research Funds

Characteristics of the Level 3 Strategy:

  • High probability of losing capital without hope of a recovery
  • Likely to be very long term in nature to allow for the full value to be realised as the investment moves from pioneering stage to mature company or industry.
  • Very low to no liquidity or ability to trade positions
  • Virtually no formal reporting
  • No real ability to independently verify valuations or conduct research
  • Access is likely to be restricted to invitation only and prescribed minimum investment levels

Outcomes achieved by a Level 3 Strategy:

Outcomes are likely to be binary – All or nothing.

If the investments pay off the financial rewards will be truly life changing.

Wealth created to such an extent it will be intergenerational.

 

Summary:

Hopefully the above framework assists in identifying appropriate investment options for all levels of your investment plan regardless of your overall net wealth position.

Securing your highest priority goals before contributing to others will likely mean that there is a trickle down from Level 1 to Level 3 but it is not necessarily associated with a specific monetary value or level of wealth.

Level 1 investment options are necessarily boring, albeit effective over the long-term, and carry a much lower probability of poor financial outcomes.

Level 2 & 3 investments are certainly more exciting and hold the promise of greater rewards but will probably not offer the greatest amount of certainty.

Sustainable excess returns are more often associated with taking on increased risk rather than through some special skill or system - Acknowledging this and matching your goals with appropriate investments will go a long way to enhancing your long-term financial well being.

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