Life is full of tradeoffs.
Making decisions related to our finances and our investments is no different. Effective decision-making around the best investment strategies for our money requires an understanding of the financial trade offs that we make if we commit to any product or plan.
A trade off simply means that I exchange one thing for another. I gain something in exchange for losing something. We make trade offs daily. For example I may choose to eat and In n Out Burger instead of a healthy meal at home. I have enhanced my goal of enjoyment and pleasure, but I have given up that money that could be used for another purpose and I may have given up sticking to my calorie or health goals (it’s probably worth it!).
Sometimes we don’t think through the trade offs we make in advance. If we do, we may be able to make wiser decisions.
Although there are a myriad of investment strategies and options for our money, we could really categorize them into three fundamental trade offs.
Understanding these three key trade offs will help us to gain decision-making confidence as we plan for our future.
1. The Trade Off of Liquidity Over Growth
The first decision or trade off that most of us make is whether to invest our money or not invest our money. The decision to not invest is done strategically in order for that money to remain fully available if needed in the future for an emergency or contingency.
This decision not to invest is a trade off of liquidity over growth. Liquidity is the full availability of money with no penalty or fee. Liquidity comes at a cost, though. And the cost is that I give up the potential growth of that money if I keep it in a liquid position of a checking, savings, or money market account.
2. The Tradeoff of Protection Over Liquidity
We all desire the protection of our investments.
Protection can come in different forms. It could be the protection of our principal investment. It could be the protection of the gains that we’ve accumulated over the years. It could be the protection of our retirement income from running out before we do.
Many financial vehicles have been developed over the years to provide protection for principal, growth, and income. The primary characteristic of nearly all of them is that the investor gives up a high degree of liquidity or availability of 100% of the funds in the initial years.
If an investor has sufficient liquidity elsewhere it does not present a problem. But if an investor lacks needed liquidity at a crucial time, it can put them in difficult position.
3. The Tradeoff of Growth Over Protection
We also desire that our money grow over time. Because of the rising cost of our lifestyle over the years, growth of our investments and corresponding income is crucial, just to keep our standard of living going. With retirements stretching three decades, a retirement strategy without a plan for growth is shortsighted.
But potential growth also comes at a cost. Very few investments have guaranteed growth. Instead they have potential growth. There may be periods of loss. Loss can not only be emotionally difficult, but can entirely wreck a financial plan if not managed properly.
When we enter into any financial strategy these three competing priorities of liquidity, protection, and growth will be at play.
Instruments of liquidity will have some level of protection, but little growth potential.
Instruments of protection will have some level of growth, but limited liquidity.
Instruments of growth will have some level of liquidity, but limited protection.
Every financial instrument must be clearly understood in full before moving forward. If the trade offs are not clear and it is being presented as only having positives with no negatives or trade offs, there is either a lack of transparency or understanding on the person making the presentation.
So how do we decide how much of our money to put into type of instrument?
We don’t do so is by allowing a financial adviser or salesperson to dictate our priorities. All financial decisions should come out of a robust process, not in the vacuum of products.
I encourage my clients to ask simple and key questions that will help them to prioritize their investment decisions.
Imagine all of your money is in a single bucket with no limitations or constraints and ask yourself the following three questions…
The first is the question of how much is enough for liquidity. It is the answer to the question, “How much of my money should I NOT invest in order to have a sufficient am0unt of liquidity for emergencies or contingencies”? This is a highly personal decision, but there are some good rules of thumb that you can follow if you’re unsure.
The second is the question of how much is enough for predictable income. It is the answer to the question, “How much 0f my retirement expenses do I want to have come in from predictable or guaranteed income sources”? These can include Social Security, pensions, rental income, or any other financial instrument that is designed to provide either predictable or guaranteed income. It is not difficult to mathematically calculate how much of our nest egg needs to be earmarked to provide the rest of our predictable or guaranteed income that is not provided by Social Security or pensions.
The third is the question of how much is enough for “what if?”. When we approach and enter into retirement there are several dimensions of risk of loss that we cannot afford to ignore if we want to maintain financial security. These risks include the premature loss of a spouse and the loss of their Social Security income or reduction of their pension income. They could also include the threat of long term care expenses, dementia, or other health-related issues.
Instead of ignoring these risks, we must identify them and determine how they will be managed, reduced, or eliminated. This may involve the purchase of different kinds of insurance to deal with the risk.
The amount needed to cover the “what ifs” can also be mathematically quantified to determine either how much of your nest egg needs to be reallocated, or if we need to increase the amount of predictable income we are trying to provide (see second question above).
Once we’ve allocated into the priorities of liquidity and protection then the remaining funds of our nest egg, by default, will be for the priority of growth.
Asking and answering these three questions will give us a much clearer picture of the amounts to put into each type of financial instrument.
Then and only then can we take more time to examine and dissect the specific strategies of each type (liquidity, protection, and growth) that may be appropriate for our unique situation.