What makes rich people rich? Looking at the spending pattern of various income groups in the U.S. makes it clear: Savings. The real difference between the rich and the poor is that the rich spend a larger share of their income on savings (pensions and insurance) and education.
Source: WSJ, Labour Department,
When building wealth, preserving wealth, and passing it to the next generation is the formula for financial success it is surprising that less than 20% of Americans do have a written plan when it comes to investing and even retirement .
The paradox in human behavior is that we are perfectly rational and capable of planning for a major event in our lives, but this is usually forgotten when it comes to investing. In fact, you will find that only a third of investors have a written plan guiding their investment strategy and retirement plans.
Why is a plan needed?
The investment world is a harsh jungle, a world of murky waters where the smartest and the most organized survive and become successful while the rest are gobbled up. A written plan short circuits our normal response to something as emotional as money. It prevents us from resorting to our gut feelings and emotions. Instead of following the herd mentality that may prompt you to make unwise investment decisions, a plan will force you to stick to a rational strategy that is underpinned by fundamental investment principles. Some of the difficult emotions that you will have to overcome while investing include:
1) The fear of failure
2) The tendency to continue with a certain approach just because you started it
3) Personal matters such as relationship issues at home
It is also important to point out the main reasons why investors fall prey to the market and lose their precious funds:
1) Omitted facts and figures mislead investors into investing in a structurally unsound company or financial instrument
2) Overconfidence makes some investors think that they are invincible and that they can always beat the market.
3) Everyone wants to be seen as a champion, the successful general capable of leading an army to victory. This can make you make investment decisions that are not based on rational thinking but rather the desire to impress your friends, co-workers or family members
By having an investment plan written down and actually following what it says, you will have dramatically increased your chances of winning and increasing the size of your nest egg or investment portfolio. The following are simple steps in creating a plan and avoiding the herd mentality and instinctual impulses that turn us into fools when investing:
1. Set up specific and realistic goals
For example, instead of saying you want to have enough money to retire comfortably, think about how much money you’ll need. Your specific goal may be to save $500,000 by the time you’re 65.
2. Calculate how much you need to save each month
If you need to save $500,000 by the time you’re 65, how much will you need to save each month? Decide if that’s a realistic amount for you to set aside each month. If not, you may need to adjust your goals.
3. Choose your investment strategy
If you’re saving for long-term goals, you might choose more aggressive, higher-risk investments. If your goals are short term, you might choose lower-risk, conservative investments. Or you might want to take a more balanced approach.
4. Develop an investment policy statement
Create an investment policy statement to guide your investment decisions. If you have an adviser, your investment policy statement will outline the rules you want your adviser to follow for your portfolio. Your investment policy statement should:
Specify your investment goals and objectives,
Describe the strategies that will help you meet your objectives,
Describe your return expectations and time horizon,
Include detailed information about how much risk you’re willing to take,
Include guidelines on the types of investments that make up your portfolio, and how accessible your money needs to be, and
Specify how your portfolio will be monitored, and when or why it should be rebalanced.
A smart investor with a written down plan and strategy has already won half the battle without making a single financial decision. By implementing the plan and adhering to laid down rules of operation, the smart investor will avoid the pitfalls caused by human emotion and behavior and end up winning big.