The new year is a time to take stock of your life and make resolutions to behave better: eat less, exercise more, be a better partner, or a more present parent. Sticking with these resolutions is hard. But for most people, even those horrible exercise classes and bland diets are more fun than reassessing how to manage their money, especially after a spell of heavy holiday shopping.
Getting our financial houses in order should be high on every list of resolutions. There are many personal finance end-of the-year check-lists, most of which call for contributing to retirement account accounts, taking distributions, and finding ways to reduce tax bills. This is all all good advice—sensible but not sufficient. We also need to figure out our risk positions and make any necessary adjustments. Here is how you do it.
1. Make sure you are saving enough
The hardest and most important part of any risk plan starts with taking an honest look at household balance sheets. And here my advice is a little unconventional. Before maxing out contributions to your retirement account, first compare your liquid savings (don’t include retirement accounts you can’t access without paying a penalty) to the debts you pay each month (mortgage, credit cards, student loans, and the like). Now compare the monthly debt payments to your income and savings. Figure out how long could you keep making payments if you lost your job.
For most people, losing their job is the biggest financial risk they face. It can mean not paying your bills and destroying your credit. The best thing you can do to reduce that risk is build enough savings to last three-to-six months.
Once you have enough emergency savings put away, then it is time to save as much as you can for retirement (which itself can be thought of as another kind of debt). This reduces the risk of poverty in old age.
2. Set financial goals
We rarely go anywhere without a destination in mind, but we often save and invest without a well-defined financial goal. Saving and investing towards a specific goal increases the odds you’ll achieve it.
When you need money—be it next week, next year, or 50 years from now, for a house, education, emergencies, or retirement—should determine how much you save and how you invest. Goal-based investing is more than putting aside as much as you can and trying to generate the highest returns possible on investments. It is saving toward a goal and picking the right investment strategy to match.
I’d suggest divide up your savings based on different goals. Figure out how much you need to save towards each goal and prioritize how much savings each will get based on how important it is. Each goal should also get its own investment strategy. This helps you figure out how much risk to take. Savings for your emergency fund should be invested in less risky assets than money set aside for retirement in 30 years.
Investing in stocks offers the possibility of higher returns, which grows your income faster than parking cash in a bank account. But if the market crashes you could lose most or all of your money, and odds are that’s when you’ll need it most. Invest in stocks for things you can take some risk on or can handle falling short of your goal. Invest in safer assets, bonds, or cash for money you can’t risk losing.
3. Diversify risk for cheap
If you invest in the stock market, you can eliminate lots of unnecessary risk by spreading money in many stocks instead of just a few. Investing in individual stocks adds more risk, without much more expected reward. And it may look tempting now, but investing your retirement savings in bitcoin is a very risky thing to do.
The new religion in personal finance is index funds. Index funds offer diversification for low fees. Actively managed funds offer similar diversification, but at a higher cost. Active funds claim they can earn more than index funds because of the skill of their managers. But most of the time, actively managed mutual funds don’t earn more than cheaper index funds; they just cost more. And if they do appear to earn more, odds are the funds are making riskier bets with their portfolios. They may look good when the broader marker is rising (like now), but probably won’t hold when stocks fall.
Take a look at the stocks in your pension and/or brokerage account. Make sure you are in index funds (your workplace retirement account probably defaults to active funds) or pay less than 30 basis points in fees.
4. Adjust the risk in your portfolio
Diversification is only the first step in a smart financial strategy. Risk management comes next.
For each of your financial goals (see point 2 above), you’ll probably want to balance index funds with safer assets like bonds or cash. Maintaining the right balance right requires upkeep: you may need to reshuffle allocations between stocks and bonds now because stocks grew faster than bonds over the past year. If retirement savings are in a target-date fund, this is already done for you.
Another risk-management strategy is insurance. Make sure you are insured for what matters most: life insurance if you have dependents, home owners insurance if you care about your things, and a simple life annuity if you want a secure retirement income.
5. Points are assets too
A valuable asset that doesn’t often get enough attention is your point balance. Make sure you sign up for every awards program you can, since most are free. Look at your travel patterns. Perhaps it is just one big family trip a year, or maybe regular business trips. Since point values get eroded by inflation and mergers, collect and spend them wisely.
If you travel less frequently, you want to spend your points quickly. If you are a frequent flyer, then you may want to save points to build airline status, unlocking a range of valuable perks.
After you figure out the airline and hotels you use most often, sign up for a credit card that maximizes your point accumulation and hopefully offers a large point bonus for signing up. Then take a hard look at your credit cards and identify the ones that charge high fees. If you aren’t taking advantage of that card’s services, call and downgrade to a cheaper version of the card (keeping award points but not affecting your credit).
The future is always unknowable, and planning is often futile. But if you devise a risk strategy and stick with it, you will be better prepared to handle whatever comes in 2018.