Personal Finance: 4

Phases of Planning and Portfolio Theory

by COL Ray E. Porter III, USA (Ret.)

The essence of planning is found in your knowing the return you need and the risk you can accept. This defines the parameters for your selection of individual investments. This understanding lets you put risk to work for you, compensating you with reasonable returns. These parameters, and the type of investments which are appropriate, change, just as your immediate needs change, through the stages of life. We will focus on investments that make sense at different phases of life for most of our membership, and on design of appropriate portfolios.

A high degree of consensus exists in financial writings about the stages of personal financial planning. While they use different numbers of steps and different names, their message is fairly consistent. Each stage seeks to establish a balance between family needs, tolerance for risk, and levels of income.

Starting Out, normally in your twenties, the family has limited income compared to their needs, but a long-time horizon for reaching major goals. These families need security, a high percentage of liquidity and a savings plan to start their investment phase.

Their budget is aimed at meeting basic needs, limiting, or paying off debt, funding an emergency fund, funding retirement account (IRA’s) and developing an investment base–also called a contingency fund. Along with budgeting, it is essential to learn smart and disciplined consumption.

Heads of families need three to six months of living expenses in a liquid emergency fund account. Mutual money-market funds are perfect, paying over six percent compared to bank savings and money-markets which can be under two percent. Listing of top funds are in monthly money magazines or at www.Kiplinger.com.

Family security is primarily achieved through job benefits and insurance. If there are debts, the next priority after 3 months of emergency money is debt reduction. Many advisors do not consider it necessary to pay off all debt before funding IRA’s. Justification is the desire to get the full benefit (TVM) in the tax-advantaged IRA. Your view should include what the Bible tells you about debt. I do not find prohibitions, but many cautions. Expensive consumer debt fits a caution and needs to be under control. Contingency money has several uses: major purchases, home down payments, vacations, kids’ schools or camps, and other intermediate expenses beyond the capability of the family budget.

This is also a good time to broaden investment knowledge as the transition from just saving to investing will evolve between starting out and growth phases. It will be different for every family as situations and starting points are unique: family wealth, working couples, delayed children, early families, large families, divorces, health, and locations of residence/assignments all make the playing field uneven.

Some will generate significant disposable income in mid twenties through earnings or life style management, while others will remain in the start-up phase well into their thirties. Being faithful to the Lord and good stewards is far more important than net worth.

Growth Phase is characterized by being able to tolerate sufficient risk to build a diversified investment portfolio. You are out of consumer debt, though you may have car loans and mortgages which are serviced within your budget by monthly cash flow. You have funded your emergency fund between three and six months living expenses, as you are comfortable. You are fully funding your IRA’s: which is where you should put your first dollar after the emergency fund. You have a contingency fund, which you add to monthly, preferably by direct deposit. Only when these conditions exist and your budget is keeping expenses plus savings in balance with income, are you ready to accept the risk of investing in equities.

You are about to move from term investments, where you loan money to the institutions for a modest but certain return, to the world of buying bond or mutual funds, where the increased risk offers the potential for greater return. Y

ou must recognize the risk in equities: even though they have returned ten to twelve percent since the Great Depression, and upwards of fifteen to eighteen percent during the nineties, during any three- to five-year period you may have losses. Only because you have living expenses, basic security and retirement funds covered is it reasonable to take equity risk. Having said that, there are no firewalls to protect you from market downturns and the potential loss of investment capital like the FDIC protects your savings account.

This Growth Phase often covers most of your working life and carries you through the college years of your children, into military retirement and into second careers or Christian service. In fact, how well you manage this phase determines how flexible you are to hear and respond to calls to service. You have the potential of having greater flexibility than is the national norm. In the civilian sector, where many people provide for their own retirements, substantially through IRA’s, company 401K’s and the like, most people age forty-five have only funded twenty to thirty percent of their retirement needs.

Many financial advisors use a steady timeline to determine how much a family needs to set aside per month. This capitalizes well on TVM, but is not possible for many. As rank/income rises, children finish college and spouses consider returning to work, the percentage of monthly income available for saving and investing often grows many fold. The key word there is "available." I have known hundreds of 05/06’s who could have lived well and still saved $1000-1,500 a month who simply failed to budget and restrict their lifestyles. Later they paid the price in anxiety, additional years of work, and in lack of flexibility in making job and location decisions.
As income exceeds needs it is tremendously tempting to stop being careful, to let budget discipline slip and to reward ourselves.

The world certainly tells us, "you deserve it," "you have earned it," or "you’re worth it." Having goals, planning, and discipline are probably more important here than in the early years. Here the parable of the stewards really plays out. Your goal is to experience Matthew 25:21 ". . . ‘Well done, good and faithful servant! You were faithful with a few things; I will put you in charge of many things. Come and share your master’s happiness!’" During this phase you develop the portfolio that gives you the financial assets to free you from many of the traps of earthly obligations and their constraints on your ability to hear the Lord’s call for your talents.

Investments during this phase should be balanced, diversified and appropriate to your goals and your tolerance for risk. Balance is achieved through asset allocation. Most financial institutions have models for stages of life which allocate slices of the pie between cash, bonds, and equities. Many of these models are uniquely civilian and do not convert directly to a military professional at a similar age. This is primarily because, with our excellent retirement program, we are less dependent on retirement accounts so we can take greater risk. We also have job security and survivor benefits which allow more aggressive investing.

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The military example has a higher percentage of equities with their inherently greater risk and greater potential for return. Risk can be reduced by increasing bonds with some degradation of potential return or by holding cash that only carries the risk of under-performing inflation. Having determined the cost of your goals (Family Financial Plan), you can now allocate your monthly savings into the mix of bonds and equities, which gives you a good chance of meeting your goals. This is asset allocation or risk management, and long term has as much impact on total return as individual stock or mutual fund selections.

Your other major tool for reducing risk is diversity, where you select a variety of different investments within each part of your allocation. "Give portions to seven, yes to eight, for you do not know what disaster may come upon the land" (Eccles. 11:2). This is your classic "don’t put all your eggs in one basket" situation. This is a very common problem with many military investors and a serious problem with those who have been clients of one of the organizations selling contracts and load funds selected by the salesman. I have seen lieutenant colonels with 225K in investments and over 200k in one high load mutual fund. No matter how good the fund, the officer was taking undue risk. "But the fruit of the spirit is . . . peace . . ." (Gal 5:22). (Sound Mind Investing links these two scriptures and it makes sense.)

A more balanced allocation within the equities slice is shown under Equity Risk on the chart below. Most sources will tell you that you need three to five different mutual funds from two or three different fund categories. Even if you have three growth funds you probably do not have much diversity because within any category, the different mutual funds have many common holdings which will react similarly to market changes. The Portfolio Theory chart sums up how asset allocation and diversity help manage market and equity risk. We will look at mutual fund categories and performance in the next article, "Investing & Markets.

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Finally, your strategy during this phase should be designed to meet several broad and changing objectives. You should be investing separately to meet (if these are your objectives) college costs, long term family security, retirement, mission work and any other personal priority. Experts consistently tell us to have separate funds and not to draw down retirement funds to pay for college, but the American middle class continues to do just that. Ideally you start early and save for both, but retirement is a much greater expense and "should not" (financially speaking) be sacrificed for an intermediate objective such as college. Money taken from civilian retirement savings at this critical point results in people working longer, retiring at a lower standard of living, or working jobs into their late 60’s and 70’s. With military retirement/SBP we have more flexibility.

Mutual funds, both equity and bond, are the choice for most of these needs. Stock and individual bonds (treasury, municipal, or corporate) can also be appropriate, but require more study and management, and traditionally are more volatile (read risky). The wide spectrum of mutual funds gives us the opportunity to select type funds appropriate to each goal and their individual holdings give us excellent diversity with reasonable cost and ease of management. They do have some cost and tax disadvantages, but they are ideal for most of us. See "Investing & Markets" for more mutual fund and stock discussion.

Protecting and Transitioning Phase is only a desired phase. Not everyone gets there or gets there with the level of blessings that require special planning and offer fabulous opportunities. Again, you are more likely to transition into this phase than wake up and say, "Dear, we are in phase three." It is characterized by having the option to retire, having family security largely anchored with assets/pensions and having sufficient assets to cover major expenses (aging parents, retirement, long-term health care, etc.) You have a reduced need for growth in lieu of dependable income. During the latter years of this phase you minimize risk-taking while giving your excess to heirs and the Lord’s work.

Back before inflation was a big issue the "standard" pie chart for retirees was ninety percent bonds. The whole stereotype of a widow’s portfolio comes from the need for dependable income, great security and no need for growth. If you had reached goals and had security, why take any risk? Inflation has modified our perspective. The real value of fixed income drops dramatically during periods of high inflation like the early eighties. Now, nearly everyone needs a portion of their allocation in growth investments which can be expected to keep up with inflation. The percentage depends on monthly needs. Keep enough in income investments to secure your lifestyle. Many advisors suggest thirty to fifty percent.

In each phase, take only the risk you need and know what you need. You only need be about right: even twenty-five percent off an ideal allocation is better than most people do without a plan. This is more art than science, but your decisions improve remarkably if you understand the financial/economic environment. Your part is to study and make ready, then pray for guidance and establish godly priorities for His resources. Then you manage. Like the successful manager said, "The harder I work the luckier I get." "Every prudent man acts out of knowledge, but a fool exposes his folly" (Prov. 13:16).

Financial advisors have different names and divisions for the phases of a financial life and one of the very best is that advocated by Austin Pryor, the Christian founder of Sound Mind Investing (The Financial Newsletter for Today’s Christian Family) and author of Sound Mind Investing. He doesn’t just describe four levels, he writes about them every month, including analysis of specific investment for each level. While the subscription is a good investment, much of the general educational information is available on the web site. His levels (phases) are Getting Debt Free, Saving for Future Needs, Investing Your Surplus and Diversifying for Safety. (My system includes diversifying within the earlier stages.)

Most personal financial models associate the phases of life with appropriate investments. The start point remains with the goals of your family financial plan and the budget, which segregates assets you have to invest. Next we will look at what is appropriate for various goals. "Commit to the Lord whatever you do, and your plans will succeed" (Prov. 16:3).

Sound Mind Investing (The Financial Newsletter for Today’s Christian Family).

Sound Mind Investing by Austin Pryor. Copyright 1996, Moody Press, Chicago.

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