In a meeting with a potential client, they asked, “How should I invest the money I just received?”
The key issues to review are:
- What is the money for?
- When do they need it?
They had just received $400,000 income from a company they were associated with. Due to the structure of the business, the tax on the income is not due for 2 years and is estimated to be about 40% or $160,000.
They were also looking to use the remaining $240,000 for an additional real estate transaction at any time.
They wanted to know what they should do with their money until they needed it.
We reviewed that when investing, there are two basic types of risk they need to be aware of:
- Capital preservation risk
- Inflation risk.
Capital preservation risk is the risk that your capital is not available when you need it.
Inflation risk is basically making sure your money grows over time as items get more expensive each year.
We discussed that they have capital preservation risk as they need the money to be a specific value in a short time period.
- $ 240,000: The Real Estate Money required at any time.
The money for additional real estate should be kept in a liquid, short-term interest type of investment to maintain its value.
The best location could be a high-interest savings account (an oxymoron today) as it may pay a bit higher interest rate than a bank account.
- $160,000: the tax to be paid in 24 months.
They had asked about investing to earn a bit higher return than a short-term fixed income type of investment as they didn’t need the money to pay taxes for 24 months.
The issue is since the cash is earmarked for a specific purpose; they can’t afford for it to be less than $160,000 in two years.
They wouldn’t want to invest in equities to potentially earn a bit higher return, and in March 2024 have the investment value drop below $160,000. (Remember March 2020?)
In general, if you need the money within 3 years you have capital preservation risk, which is the risk that the capital is less than required. The prudent thing to do is to keep the investments safe so they will be there when needed.
Excerpts from the Book – Preserving Wealth – written by Jack Lumsden, MBA, CFP®
“There are basically two main types of risk: capital preservation risk and inflation risk.
“Capital preservation risk is the risk that your capital is not there when you need it. Let’s say you were going to buy a new boat in a year, and the cost was $25,000. To make sure you had the $25,000 in a year, you would have to invest in conservative investments, such as a high-interest savings account, so you’d have the $25,000. If you invested in equities/stocks, in a year you could have more than $25,000 or a lot less.
“Inflation risk is basically making sure that your money grows over time as items get more expensive each year. Even inflation of 2% over twenty years, as in the prior example, can lead to costs increasing dramatically.
“Even if you’re close to retirement, you still need some growth in your portfolio, because people today are living longer, and the longer you live, the greater the chance is that inflation will beat you. I’m sure you all want to live a long time, but you don’t want to outlive your supply of money, so your financial plans should be based on a projected life span to your mid-nineties. That means Sally needs her money for the next sixty years, and Mark for another forty-two!”
Mark looked surprised and took a sip of his drink. “Wow, that is a long time. I wonder if I’ll still be water skiing then!”
Sally started to laugh and said, “You can barely water ski now! You only go once a year after a few brown pops!”
Uncle Wayne coughed to get our attention and continued. “So you all will need growth or equities in your portfolio to keep up with inflation. A globally diversified portfolio is made up of both bonds and stocks/equities from countries around the world, and the breakdown is determined by both your goals and your risk, or sleep at night, factor.”
“What specifically do you mean by goals and sleep at night factor?” asked Sally.
“Let me try to answer that,” Alice went on. “For short term goals, say when you will need the money in less than five years, you’ll want to use conservative or defensive investments like short term-bonds, GICs, or high-interest savings accounts, so that the money is there when you need it.
“Longer term goals can be more difficult to plan for. For example, if you can attain your retirement income goals based on only investing in GICs and/or bonds, then the risk of your portfolio will be low, and it will not fluctuate much. Since your money growth is more consistent, you’re better able to sleep at night, because you really don’t need to worry too much about your portfolio declining in value.
“However, for many people, us included, to achieve our retirement income goals, we need higher returns than what bonds or GICs can provide … so we must invest in stocks. This is where the sleep at night factor comes in. The greater the allocation to stocks or equities, the greater the fluctuation—daily, monthly, and annually—of the portfolio returns and portfolio. This fluctuation of returns is called your risk level, or sleep at night factor. If you can’t sleep at night because your portfolio value changes too much, you may need more capital preservation type of investments in your portfolio; however, if you do this, you may not generate the returns required to achieve your goals. So how did I do, Uncle Wayne?”
For more information you can refer to Preserving Wealth: The Next Generation – The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®
For your FREE Copy CLICK HERE
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Jack Lumsden, MBA, CFP® Financial Advisor, Assante Financial Management Ltd.
This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see me for individual financial advice based on your personal circumstances. The information provided is for illustrative purposes only. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.
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