List Your Financial Objectives. DEVELOP YOUR FINANCIAL PLAN 

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List Your Financial Objectives. DEVELOP YOUR FINANCIAL PLAN

The investment process begins with a financial plan that lists your financial objectives and the road map to achieving those objectives. If you don’t know where you are heading, you won’t know how to get there.

The first step in any investment plan is to determine what you want to achieve from your investments and when you want this money to be available. You probably have many objectives, namely, saving for retirement in 20 years, paying for your children’s education in 10 years, and making a down payment on a vacation house in 2 years. Financial objectives are the financial milestones that you would like to achieve through investing. Take a few moments to list your financial objectives and determine how much you want to achieve with each objective in the future. Possible objectives include:
* Funding an emergency fund within one year
* Funding the purchase of a car in five years
* Funding a child’s college education in 10 years
* Building a retirement fund over the next 25 years

Investing for retirement is not the same as investing for shorterterm objectives owing to the time horizon and risk factor.

Time Horizon

Listing the time horizon is important because it gives you a better idea of how much you will need to fund each objective. The amount of money that you have to fund each objective is directly related to your financial condition or net worth. Table 1–2 illustrates how you can determine your net worth. Net worth is the difference between what you own and what you owe.

Reviewing your monthly budget also may assist you in determining how much you have to invest and the level of risk that you can accept.

Table 1-2
What Are You Worth?

List What You Own (Assets) Minus List What You Own (Liabilities)


Evaluate your objectives with regard to risk, which may be characterized as follows:
* Safety of principal
* Stream of income
* Capital growth

Safety of Principal Money market securities, such as bank accounts, savings accounts, CDs, money market mutual funds, Treasury bills, and commercial paper, offer safety of principal and low rates of return. Short-term objectives such as building an emergency fund and saving for short-term purchases within the year fall into this category of investments. Returns from these securities often do not cover inflation and taxes.

Stream of Income Investments that provide a steady stream of income with higher rates of return than money market securities include bonds and preferred stock. The tradeoff in seeking higher levels of return from bonds and preferred stock is the possible loss of principal. When bonds and preferred stock prices decline below their acquisition costs, investors experience losses of capital (principal loss) should they have to sell their investments. High-risk, high-return bonds (junk bonds) offer the potential of higher streams of income than investment-grade bonds, but junk bonds are also more likely to default on the repayment of principal to their bondholders. Investors looking to fund objectives with one- to five-year time horizons use bonds with matching maturities to their time horizons to earn higher rates of return than money market securities.

Capital Growth Investing for capital growth has the potential to provide an increase in value of the investments also referred to as capital growth. Stocks offer the potential for capital growth when stock prices increase above their acquisition prices. The risk is that a stock’s price can decline below its acquisition cost, resulting in a capital loss. For this reason, you need a longer time horizon (greater than five years) in order to be able to wait out any losses in the stock market. Some stocks pay dividends, thereby providing stockholders with a stream of income. Generally, the yields on dividend-paying stocks tend to be lower than the yields of bonds. However, not all stocks pay dividends, and investors invest in these stocks for their potential capital growth. Stock investments are suitable to fund investors’ longer-term objectives (with a time horizon of greater than five years), such as building a retirement fund.

In summary, there is a tradeoff between risk and return. Lowrisk investments (money market securities) guarantee principal but provide low returns in the form of income. Fixed-income securities (bonds and preferred stock) provide higher levels of income but carry a risk of loss of principal in the event of default for bonds or having to sell preferred stock at a lower price than the purchase price. Common stocks offer the greatest total return (capital growth and income) over long periods of time but carry a higher risk of loss of principal over short periods of time. Your personal circumstances (age, marital status, number of dependents, net worth, and income) determine your tolerance for risk as a guide to your choice of investments.

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