The Rules of the Road for Investment Strategies
VCE Agricultural and Applied Economics: Finance, Capital, Credit, October 1995
By David M. Kohl, Alex White, and Dixie Watts Reaves
In the last issue, the retirement worksheet was utilized to determine the amount needed to be saved in order for producers and small business owners to reach their retirement goals. In this article, we will discuss some of the rules of the road that need to be considered to enable an individual or family to develop a successful, well-designed investment portfolio.
Goals and Objectives
The first rule of the road in the investment strategy is to know your objectives. Each investment has a certain degree of safety, income and growth potential, and possible tax benefits. Typically, there is a trade-off between safety (risk) and income (return). An investment goal that is heavily weighted toward safety may sacrifice income and growth potential. At the other end of the spectrum, an investment that is growth-oriented may lack safety and security. Each investment has a certain amount of safety, growth, income, and tax benefits. It is up to each individual to determine the balance of these benefits in each investment.
Real Rate of Return
The second rule of the road in the investment strategy is to determine the risk with each investment. A recent study completed by Dr. David Kohl and J.R. Marker of the Agricultural and Applied Economics Department at Virginia Tech found that most agricultural producers perceive risk as the loss of principal or the money invested. However, another risk in investing is when the returns on the investment do not maintain pace with or exceed inflation. In investing terms, this situation is known as the real rate of return (the difference between the rate of return and the rate of inflation) for a given period. For example, a certificate of deposit that is generating a 3 percent after-tax rate of return would have a negative 2 percent real rate of return if inflation is 5 percent. Similarly, a mutual fund that is increasing at an 8 percent annual rate while inflation is 3 percent would have a positive 5 percent rate of return.
Rule of 72
Risk in investing can be analyzed by using the Rule of 72. The Rule of 72 tells you how many years it will take before your portfolio doubles, given a rate of return: number of years for portfolio equals 72 divided by rate of return. That is, if the rate of return is 8 percent after tax, your investment portfolio will double every 9 years (72/8). On the contrary, if inflation is 4 percent, then the purchasing power of a dollar is cut in half every 18 years (72/4). Thus, when investing, it is critical to balance your objectives and still maintain a positive real rate of return. Retirees on fixed incomes, or someone with an investment strategy focused on safety, will frequently fall victim to a negative rate of return, thus causing a reduction in the purchasing power of the investment portfolio or a lower standard of living. In foreign countries, where inflation rates are 30 to 40 percent, one can readily see how the elderly suffer economically, especially when the rate of return is lower than inflation.
A knowledgeable investor learns to balance the risk with reward. As a general rule, the higher the risk, the higher the yield. For example, a savings account, which is guaranteed up to $100,000 by FDIC, is safe, but the return may be low. A new issue of a certain stock may have a high rate of return, but may be very risky.
The next rule of the road is to establish a strategy of diversity. All too frequently, an agricultural producer or small business owner will leave retained earnings in the business in order to expand the business. This strategy, while providing high returns in the short-run, has the potential for the owner having to finance 100 percent of his retirement. Asset allocation, i.e. the percentage invested in different investments, can be used to build a diversified investment portfolio. A 1995 Virginia Tech study conducted by Drs. Alex White and David M. Kohl of the Agricultural and Applied Economics Department found that ending net worth or wealth was much higher using a more diversified strategy for producers and small business owners. Thus, diversification has the benefit of reducing risk but actually increasing returns. Many agricultural producers and business owners are equity-rich and cash-poor. Frequently, they develop elaborate estate plans for their deaths, but find themselves cash-poor until death. A reasonable retirement program should provide for cash flow in retirement for at least 18 years for males and 22 to 25 years for females.
More producers are seeing the benefits of diversity in retirement planning. For example, a dairy farm couple was in the process of transition management with their son and daughter. The couple had a pension, because both had driven a school bus and qualified for a 403(B) fund since they both worked for a non-profit institution. In years when business income and cash flow were strong, they contributed the maximum allowable amount to a Simplified Employee Pension (SEP) plan. Currently, they are in the process of selling their farm business to the son and daughter. Nearly 80 percent of the cash flow needed in retirement to maintain their lifestyle will come from the diversified investment portfolio outside the farm business, i.e. their SEP. This planning has allowed the son and daughter to gradually purchase the dairy farm from the mother and father, while the parents can still be involved in the farm at their discretion and not be dependent on the farm's earnings as the sole source of their retirement income. Also, if the parents sold the farm outside the family, they could sell it at their discretion. This could lower risk and actually increase net proceeds through sales and tax management strategies.
Timing is another rule of the road in the investment strategy process. First, most individuals complain they have little or no earnings left to invest. It is essential in investing to pay one's self first. Those who see the money will have a tendency to spend it. Second, the most effective strategy in many cases is to invest at regular intervals or utilize the concept of dollar cost averaging. With dollar cost averaging, the individual invests the same amount of money regularly into similar investments rather than investing in one lump sum, thus capitalizing when price is low and purchasing fewer amounts when price is rising. This process allows an individual to have money withdrawn from income on a regular basis, particularly if he/she is employed part-time or full-time.
As with any planning process, a step-by-step approach can simplify the process. The same holds true for retirement planning. The following steps provide a general guide for the investment strategy process:
A team approach to financial planning is highly recommended. On this team, each individual "player" should be an expert in his/her field. Realize that one person is not likely to be an expert in all fields of financial planning. The financial support team should include:
One may also want to include an investment expert (broker) on his/her financial support team.
The individual should determine what he/she would like to do, and what he/she thinks he/she will be able to do during his/her retirement. This step involves talking things over with the spouse, the family, and the financial support team.
A person is more likely to accomplish his/her retirement goals by writing the goals and plans on paper. He/she can also avoid future problems by keeping his/her written retirement plan and financial records in a safe place. This practice provides the family with important information in case something happens to the individual!
The best plans in the world are worthless unless they are put into action. One must start early! Procrastination is one of the worst enemies of retirement planning! The individual needs to work with the financial support team to properly enact the retirement plan.
The individual must take responsibility for monitoring the performance of the retirement plan. Periodically review the performance of the plan and work with the financial support team to update or alter the plan in order to accomplish the stated goals.
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