Creating and Implementing Your Investment Strategy – Part 1 – The Liquidity Test

 

In a previous posting series (see 1st link below), I walked everyone through the steps in David Bach’s book Smart Couples Finish Rich for how someone can create and implement a Purpose Focused Financial Plan.

As a final step to this series, I discussed the specific financial actions that a person can take to put this plan in to action (see 2nd link below):

In order to save money for longer term life dreams, David recommends using index mutual funds to accumulate wealth.

In the link below where I defined my asset allocation objectives/targets, I mentioned that I had defined the allocation levels based on several finance books that I have read. However, I did not go through the exact step-by-step details of how I arrived at the levels.

My Investment Strategy

Since this is a very useful and interesting process, I wanted to dedicate a series to discussing how I (and you) can do some “self-searching” and arrive at a personalized investment strategy that you can then review with your financial advisor.

 
Step 1 – The Liquidity Test

The first thing to determine is whether or not you have enough cash or liquid fixed income investments on hand for what is called an “emergency fund.”

As described in the link below, you should keep enough cash on-hand for 6-9 months of expenses. These should be available for you to tap in to in the event that you lose your job or are injured (and cannot work).

Account Hierarchy

Step 2 – Forecast Your Cash Needs for the Next 20 Years

After making sure that you have saved up enough money for your emergency fund (and made a mental note of the quantity), you must now plan for any expected cash needs for the next 20 years. The purpose of this exercise is to help to determine the minimum % of your assets need to be fixed income and which can be held in higher-return-producing equities instruments.

To get you started brainstorming, several cash need examples are listed below:

  • Emergency Fund – most important thing
  • House down-payment
  • College tuition for you or your children
  • Purchasing a car
  • Engagement ring purchase
  • Future vacations
  • A high-end $6000 bicycle
  • A motorcycle
Remember to review your life values and life dreams created in the posts at the link below to figure which need to be included in this exercise. It is very interesting how all of these personal finance topics are connected!

Identify Your Life Values

Identify Your Life Dreams

Once you have thought about what cash needs will come your way in your life, click on the link below to access a template I put together for you to list a written and $ value description of your future cash needs.

Just download an Excel copy of the spreadsheet on to your desktop in order to be able to write your values in. Also, be sure to place the cash requirement in the appropriate year in which it will be used.

Google Docs – Forecast Your Future Cash Needs

After you type in your forecasted cash needs, the spreadsheet will then automatically calculate the total $ value that you need to invest in fixed income securities right now in order to meet your cash requirements/objectives. This quantity is displayed in the light purple cell, designated H3.

This total quantity is found by multiplying the cash needs by the appropriate (1- Maximum Equity Exposure Percentage) rate.

Once you have entered your forecasted cash needs and obtained the $ value from cell H3 that you need to have invested in fixed income investment instruments, you then need to perform the following steps.

  • Enter the total amount you have available to invest in cell I3. The spreadsheet will automatically calculate the % of your assets that you should have invested in fixed income securities in cell J3.
  • Next, perform a reality check.
    • Compare the $ value that you should have invested in fixed income securities to the total amount of money you have available for investing.
    • If the number is greater than the total amount you have available to invest, you may need to reduce your cash needs.
      • Ask yourself – “how fancy of a house can you really afford?” – Maybe you cannot afford as high of a downpayment as you expected.
      • Ask yourself – “do I have enough money to pay for my future child’s education?” If not, you should not feel bad about the fact that you need to secure your own financial future before setting aside money for their education.
  • After making any adjustments needed to your forecasted cash requirements, make a record of your finalized % of your assets that should be allocated to fixed income instruments from cell J3.
  • This value will be used going forward in the next post of this series to make a final determination of the % that you should allocated to fixed income instruments.

To read Part 2 of this series, click the link below.

Creating and Implementing Your Investment Strategy – Part 2