The path to financial freedom
THE end of the year is a time for catching up with family and friends, letting your hair down, having some fun and er... reviewing your financial health.
We tend to under-estimate the power of planning for our financial future. A simple arithmetic tool will show that it is never too early to prepare for one’s golden years – it is called the power of compounding, which teaches us the sooner we start saving (and investing), the faster we will become affluent enough to be financially free.
Let us illustrate. Let’s take an 18-year old who enters the workforce and starts saving US$2000 a year for the next seven years till she is 25.
Then, let’s say she stops saving, and lets the savings (parked in diversified investments) compound at a rate of 10% a year. A simple calculation shows that by saving a total sum of US$14,000 in the first seven years of her working life, our saver would become a dollar millionaire by the time she is 66.
Now let’s take the case of her friend who starts saving much later, when she is 26. For her friend to become a millionaire by the same age as her, she will need to save US$2000 every year from the age of 26 till she is 66, or a total sum of more than US$80,000 over a span of 40 years, and let the money compound at the 10% rate.
That’s the advantage of starting to save and invest early.
Now, having built up a sizable nest-egg, how does one gainfully deploy the savings to become financially secure as soon as possible, whether in preparation for the more mature years of our lives or to financially secure the future of our children?
The most common practice is placing one’s savings in bank deposits. This is understandable, given the security offered by such deposits. However, it is important to consider the “real” returns on these savings after taking into consideration the rates of inflation.
Against this backdrop, when one considers capital preservation, diversification across sever- al investment solutions becomes critical. Apart from bank deposits, one of the most common ways to preserve and increase wealth is through insurance solutions, such as annuities and endowments.
Insurance solutions, which are typically long-term in nature, offer defined returns after a certain date. The flip-side of this certainty is their lack of flexibility – one cannot access them easily in times of emergencies.
This is where an allocation to a diversified basket consisting of stocks, bonds and precious metals becomes useful. These assets are more fungible than the usual insurance products and come in handy when one needs to fund various life-cycle needs, such as financing for children’s education or marriage or for health emergencies.
For those who can, diversifying a part of one’s investments internationally would help spread the sources of risk.
Research shows allocating part of one’s wealth in such diversified investment baskets is also key to boosting overall returns. Historically, stocks have delivered higher returns than bonds (for instance, the diversified MSCI global equity index has provided returns almost nine times the original investment over the past 30 years, despite several major bear markets during that period).
Hence, an investment basket consisting of 50% stocks and 50% bonds (or bank deposits) would provide a higher return over an extended time-period than one exclusively parked in bank deposits.
The traditional approach to allocating between stocks and bonds is to put a larger share of one’s investment capital in stocks compared to bonds during the early part of one’s working life. This ratio inverts as one heads close towards retirement and the need for wealth preservation becomes increasingly important.
A ballpark rule for the allocation between stocks and bonds has been to allocate (100 – your age)% to stocks. So, if your age is 40 years, the typical advice would have been to allocate 60% of your investments to stocks.
Of course, as life expectancy increases, this rule-of-thumb may need to be modified to increase the allocation to stocks, especially if one is looking at succession planning.
Meanwhile, one also needs to consider the stage of the market and business cycle we are in to fine-tune one’s asset allocation between stocks and bonds.
Although the current global equity market recovery is the second-longest on record, recession risks remain muted due to a combination of loose financial conditions and earnings upgrades.
This is supporting stocks and other risk assets globally. With global growth expected to accelerate modestly and inflation to remain subdued, there is likely room for further upside for risk assets.
This is not to ignore the higher asset valuations and the late economic cycle we are in, but synchronised economic growth and still loose monetary policies worldwide suggest risky assets may have more room to run.
This would justify a pro-risk tilt in one’s asset allocation. However, today’s late-cycle conditions and low volatility place even greater importance on a broad diversification across asset classes and an overall emphasis on risk management.
A faster pace of removal of accommodation by central banks, excessive risk-taking, geopolitics and China’s deleveraging and its likely impact on global trade and commodities are among the risks one needs to monitor.
In any case, given the run-up in markets, it is good discipline to periodically rebalance one’s allocation back to one’s target allocation to ensure it is aligned with one’s overall risk-and-return objectives.
In conclusion, securing one’s financial future starts with a well-thought-out plan, after considering one’s life goals. The next important step is to save and invest early. It is never too late to start, but if we are starting on financial planning at a later stage of our lives, we should ensure that our children start early.
Finally, by diversifying savings across various investment solutions, we can generate better risk-adjusted returns. This would go a long way in making us financially free to enjoy our golden years.