SMART SPENDING recognises the need to consider life stages and to provide for them. Spending wisely involves thinking carefully of how you would like your life to evolve over the short, medium and long term.
So understanding the time value of money and the need for delayed gratification is very helpful. However, appreciating that risks cannot be avoided is the next big hurdle.
To save and invest for the future involves taking investment risks. The risk is that you may invest expecting to get an eight per cent return on your investment and instead get an undesirable outcome – say, a much lower return, or even erosion of all or part of the principal invested. Various factors contribute to different investment risks. The point is that each time you invest there may be six possible outcomes:
• You may recover only your principal;
• You may earn a lower return than expected;
• You may earn a higher return that expected;
• You may lose part of your principal;
• You may lose your principal completely; or,
• You may not only lose your principal but also create debt or a deficit.
There are risks in investing, yet living a productive life also has its risks. You can get into an accident or have a major setback at any time. Even walking the next few steps, you may stump your toe or trip and break an arm. The goal therefore is not to avoid risks, rather to understand as much as possible about the risks and take prudent precautions where possible to minimise the effects.
In addition, there is the general rule that the higher the risks, typically the higher may be the return. So, for example, a young person in their 20s may choose to invest in their small business idea, throwing all their passion and hard work at it in the hope that it will be a success in funding their lifestyle later in life and during retirement. However, the failure rate of new small business is over 70 per cent. So, this would not be an investment that would be readily recommended for someone who is now starting to invest for their retirement and is over 50 years old.
Investing in a small business is one of those risky undertakings where it is likely that, not only you may lose your principal investment, but the residual debts of the business could place your personal financial plans over the next few years in jeopardy. For an older person, there would be even less time to recover and to build up an adequate retirement nest egg. On the other hand, a younger person may have time to change investment tracks and so stand a better chance of recovering in time to still have an ample nest egg at retirement. Yet a striking anomaly is the famous Colonel Sanders who franchised his chicken business when he was 62 years old and realised that he did not have an adequate pension.
That brings us to another factor of risks – the person’s disposition to the risks of investing money. If the possible outcomes of an investment may stress you unbearably, you will lower your exposure to high risks and tend to settle for more modest returns. Alternately, depending on the level of accumulated wealth, a person may be willing to undertake high(er) risks with part of their investment. If that principal is lost or eroded, the stability or growth of the other investments will minimise the effect of that loss. This balancing of risk approach is applied in establishing balanced mutual funds drawing from investments with varying risks.
Ultimately, spending your money wisely involves planning to spend in the future, therefore you need to save and invest. You cannot avoid investments risks; your goal is to try to understand as much as possible about each investment’s risk parameters and in so doing, minimise your risks according to your circumstances and outlook.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. She can be contacted at louisefairsave@nationnews.com. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.