Defining financial goals may help you plan and choose the right investments. Goals can be simple and short-term or more complex and long-term. For example, short-term goals could be raising money for a wedding or a trip, and long-term goals could be to buy a new car, a new house, or your own retirement.
If you don’t have a specific goal, just define an amount that you wish to have and the date by which you want to achieve this financial goal. Follow these simple steps to achieve your financial goals:
Establish Your Financial Goals
First, you need to define what you want to achieve with your investment. Is it just protection against inflation? Do you want to retire or save money for a child’s education? Maybe you want to buy a house or an already well-established business? The more specific the financial goal, the better the chances of achieving it.
Know the Monetary Value of Your Financial Goals
Calculate how much money do you need to accomplish your financial goals. To do that, you should find out the current fair market value of the goal you want to accomplish and include inflation in upcoming years.
Available Money for Investing
Step three is to see how much money can you put aside for investing. You must have at least 3 months of savings to cover your monthly expenses if you lose all sources of income. The more you have, the better. After your saving egg is safe and sound, you can see how much money can you put aside to accomplish your financial goals. Be realistic here.
Step four is to see at what time you want to reach your financial goal. If this is a long-term goal, it usually takes 5+ years and short-term goals are around 1-2 years.
There are two risks you should consider
- Risk capacity
- Risk tolerance
How much risk you can financially bear is characterized by risk capacity. Further, risk tolerance is a measure of how much risk you can withstand emotionally. Certainly, knowing both of these risks will help you to understand the amount of risk you could take to maximize the chances to reach your goal. If you want to learn more about what risk itself is, read the article from Investopedia.
a) Risk capacity
Investors with higher risk capacity are generally 10 or more years away from their financial goal. It’s usually a desirable option for investors in their 20s and 30s because they are far away from retirement. They can invest in risky investments like equities, which offer higher long-term returns but are prone to price volatility along the way.
It is recommended for investors with lower risk capacity to invest in less volatile asset classes because their portfolio has less time to recover if the markets drop. In this case, you would own more bonds and cash when saving for a short-term goal. If your goal is two or fewer years away, you might consider holding all in bank deposits or cash.
b) Risk tolerance
You should also consider your ability to take risks. You may be able to examine this by looking at your feelings during market changes. For instance, how do you feel when a major drop happens and your portfolio is down by 50%? It’s hard to know until a situation arises, but if you think you would be embarrassed, then you might have lower risk tolerance. Therefore, you should consider safer investment instruments.
Now Create Your Financial Goals
After you go through all five steps, it is time to play with the compound calculator to see which variables you need to adjust. As a result, you will see if you are over-optimistic or perhaps over-pessimistic. Let’s find out as I go through an example.
Example – buying real estate
Let’s say you want to raise 200,000 euros to buy an apartment. You came to the value of the apartment by looking at the current market prices, so you must take into account that you will have inflation (say 2% per year) during the next period, so the price of such an apartment today is 163,000 euros.
You want to buy an apartment in 10 years. The question is how much money you have to set aside per month and at what interest rate to reach the desired goal. For this calculation you will use the already known compounding calculator:
If you look at the calculation, you can see that with an interest rate of 7% per year in 10 years, you have reached the amount of 200,000 euros. Importantly, you were making monthly deposits of 1,160 euros per month. In the calculator, you can test different inputs. Therefore, you can see if that goal suits you or if you need to change some variable.
For example, 7% of the yield may be too much of a risk for you because you do not like to invest in index funds. As a result, you would rather consider safer forms of investment with a lower yield. Additionally, you would invest more per month and got the same result which is 200,000 euros.
Or you can simply prolong the time horizon and invest for 12 years instead of 10. You have a lot of options, what you need is to choose the one which suits you.
Now that you know all the basic steps to determine your financial goals, nothing is stopping you from creating all the variables needed to achieve it. If you have not yet decided which financial goal you want to achieve that is fine, you can know the approximate amount. However, it is important to determine it and move towards it. Think about your financial goals and answer the following questions:
- What are your financial goals?
- How much money do you need to achieve them?
- How much are you able to set aside each month to invest?
- What is your time horizon?
- What is your risk appetite?