Setting Your Financial Goals

“It’s not what a particular investment might or might not do that makes it right for you. Rather, it’s whether that investment fits with your personal investment goals, investing style and personality.”

At first glance, you may think the point of investing is to increase your net worth. In some parts of your financial life, that’s certainly true…. but not in all. In many instances, investors have additional objectives for investing that can be very specific and short-term in nature – like buying a car, saving for a vacation, or building an emergency fund.

Before you begin making any investment decisions, there are three critical steps you should take no matter what your objective is in the end. The three lessons comprised in Module One will cover each of these prerequisites in detail, beginning with the first – setting your financial goals.

Is a stock that has a good chance of doubling in value over the next four years a good or bad investment for you? There’s no quick response to that question because the answer can be different depending on the individual investor and his or her financial goals.

In this section, you’ll learn…

• common financial goals that investors set for themselves
• key factors to consider when setting your financial goals
• the importance of your investment choices fitting with your financial goals

Just what you plan to do with some or all of your savings – and when you plan on tapping into it – should underpin most of your major investment decisions.

Begin investing by looking at the big picture. Consider how investing and your investment choices fit into your larger financial situation

The following are some typical financial goals that investors set for themselves:

• Building and maintaining a sufficient emergency fund – a reserve you can draw from if you run into unexpected expenses, or your income is suddenly curtailed or cut off.
• Putting money aside for short-term goals – whether it be a dream vacation you hope to take in the next few years or a major home renovation project.
• Saving for your family’s education – to pay for college or university tuitions and related expenses.
• Investing to meet your long-term goals – to provide a comfortable lifestyle when you cash your last paycheck and enter retirement.

Without an emergency fund, you may be forced to sell long-term investments at a loss to meet a cash-crunch.

And each specific goal requires a somewhat different approach to investing. In each case:

• you have a different time frame to consider.
• the degree of volatility you can tolerate also varies from goal to goal.
• there are tax implications to think about as different types of investments get taxed in different ways and at different rates.

Let’s look at each of these in turn, beginning with your time frame.

Since you spend after-tax dollars, it’s your after-tax return that’s the most important measure of performance for investments outside of a tax-sheltered investment account.

Factoring in Time-Frame When Setting Your Financial Goals

Put money into an investment, and there’s a likely point at which you’ll want to take it out – be it for repairing the roof next spring, sending your teenager off to college in five years, or retiring in three decades.

The general rule to remember is the longer you have before you need to sell the investments that you are holding for a specific purpose, the more risk you can take.

Consider your retirement savings. You might have two or three decades before you need to touch that money. In this case, your goal allows you to take on all sorts of calculated risk. You can put a good portion of your savings into the stock market since you have the luxury of time to ride out the market’s regular downturns, leaving you to enjoy its long- term returns, which typically beat out other types of investments.

The converse of this is also true: The shorter your time frame, the less risky your investments should be. If you need the money in just a couple of years for instance, you should invest it in cash-type investments that guarantee your principal will be protected with the ability to quickly turn those investments into cash.

Risk and reward go hand in hand. If you want the higher returns offered by stocks, real estate, and small business, you have to assume more risk.

Factoring in Volatility When Setting Your Financial Goals

There are two factors to consider when deciding how much risk you can take with your investments. The first is your timeframe, which we just reviewed.

The second factor is your personality. There is no point in investing in things that make you uncomfortable. Not only will you likely lose sleep, you’ll likely lose money. Purchasing investments that leave you on edge will, in most cases, have you making costly decisions when the stress becomes too much to bear.

Many investors can effectively describe their personality, but have trouble determining the level of risk they can comfortably bear when considering investment options. In Lesson 3, we’ll be discussing risk in greater detail and helping you determine your individual risk tolerance – a critical requirement before making any investment decisions.

Investors who understand their risk tolerance have more comfort in their investment choices.

Factoring in Taxes When Setting Your Financial Goals

Many investors account for the effects of inflation in their financial decision-making, but forget to factor in taxes. That’s a mistake. Taxes can have a dramatic impact on what ends up in your hands.

When considering any investment vehicle – be it stocks, bonds, retirement accounts, or your bank account – understand the tax implications as well. Don’t just look at the reported or advertised return on an investment and make your decision solely on that basis.

The information in the following pages helps you understand the implications of:

• Tax on Bank Accounts
• Tax on Bonds
• Tax on Stocks
• Tax on Retirement Accounts

To make your money grow after factoring in inflation and taxes, you’ll need to take some risk in order to beat the cost of living.

Tax on Bank Accounts

Take your plain-vanilla savings account. Many people leave a lot of money on deposit with their bank. Why? It’s guaranteed that they’ll earn a certain return, and after all, the stock markets and other types of investments are so risky!

The problem is many people forget to factor taxes into their thinking. Suppose your bank account yields 3 percent. You don’t actually get 3 percent. You have to pay taxes on those earnings, which cuts into your profits. If you are a moderate income earner, a 3 percent bank account only earns you around 2 percent, once taxes are taken into account.

Tax on Bonds

Things get a little more complicated because some investments are taxed at varying rates. Interest paid on bonds, for instance, is generally taxable. However, you can also buy bonds that let you earn some or all of your return in a tax-free form. The interest on U.S. Treasury bonds, for example, isn’t taxed at the state level. Municipal bonds, issued by state and local governments, pay interest that is free from federal tax, and also free from being taxed at the state level if you are a resident of the issuing state.

Keep just enough money in your bank account to cover your day-to-day needs. Keep extra liquid savings in a money market account where you’ll earn a much higher interest rate.

Tax on Stocks

The money you make on stocks is also taxed in different ways. For starters, some stocks pay dividends, which are taxable. You are also taxed on your profits if you sell a stock for more than what you paid for it. But there are two different tax rates. If you sell a stock that you bought less than 12 months earlier, your profits (called capital gains) are taxed at your marginal tax rate.

If you buy stocks (after December 31, 2000) and hold them for at least 12 months before selling, your gains are taxed at 18 percent if you are in the 28 percent tax bracket or higher. If you are in the 15 percent tax bracket, your capital gains are taxed at 8 percent. (For investments purchased prior to January 1, 2001, capital gains are taxed at a minimum of 20 percent for those in at tax bracket of 28 percent or higher, and 10 percent for people in the 15 percent tax bracket.)

Tax on Retirement Accounts

There is one way not to pay any ongoing tax on your investments. If you put money into a retirement account, your money can grow without being taxed. You only pay taxes on this money when you take it out of the account. (In many cases you also get to claim a tax deduction for money you contribute to a retirement account).

If you work for a for-profit company, you may have access to a retirement plan known as a 401 (k) plan. Employees of nonprofit organization are able to save through a 403(b) plan.

If you are self-employed, you can also take advantage of the tax-free compounding offered by retirement accounts. These may include a Simplified Employee Pension – Individual Retirement Account (SEP-IRA), or a Keogh.

Finally, if you have employment income, you can also contribute to an Individual Retirement Account (or IRA). While the money inside an IRA enjoys tax-free compounding, you may or may not be able to deduct your contributions, depending on your specific circumstances.

Key Learning Points

• Before making any investment, you should first define your financial goals.
• When defining your financial goals you have to consider time frames, degrees of volatility and tax implications as each will impact the investment choices you make.
• In addition to your financial goals, your personality is a key decision factor as to how much risk you can bear with your investments.
• In addition to taxes, inflation can also have an impact on your investments’ rate of return. Therefore, both must be factored into your financial planning.