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Course 504
The Investing Pyramid

Introduction

Do you remember the U.S. Department of Agriculture's food pyramid? Even though the USDA abandoned the pyramid as an image to help set dietary priorities, it's still a useful shape to convey how to allocate your time and resources, including when you're investing.

At the bottom of the pyramid are the activities that you should spend the most time and energy on because they have the biggest impact on your results. They're the equivalent of broccoli and brown rice. Meanwhile, at the top are tasks that, though worthwhile, will have a smaller impact on your bottom line.

Here's a look at the investment pyramid Morningstar’s Director of Financial Planning, Christine Benz, would propose, ranging from what should be investors' top priorities--the base of the pyramid--to the least important ones. If you have a finite amount of time to devote to your investment activities, this can help guide the way.

Pyramid's Base: Set Goals

You know how it is when you don't start a day with a to-do list? You get buffeted around by whatever comes up. Phone calls, answering emails, chatting with colleagues about favorite childhood candy bars, and whoops--how on earth did it get to be 11:20 already?

Managing your finances without first articulating your near- and long-term goals is pretty similar. The days will go by, and you'll no doubt find plenty of ways to spend your money. But you won't necessarily get to where you really wanted to go. Rather than operating with the amorphous goal of "wealth accumulation," take a step back and articulate the specifics of what you're trying to achieve, when you'll need the money, and how much.

Paying the full freight for college for each of your kids? Retirement while you're still young enough to enjoy it? A move to a bigger house within the next five years? By quantifying each of your financial goals, you may see that it's not going to be possible to achieve them all, but it's better to know that early on so you can prioritize. And each of those goals likely carries its own time horizon, which in turn will dictate what types of investments you hold and where.

Once you've set your baseline goals and quantified how much they'll cost, checking your progress toward them can serve as the ultimate financial checkup; monitoring specific investments is secondary.

Next Band: Manage Saving/Spending Rates

Budgeting is boring, which is why it's easy to give short shrift to it in favor of sexier pursuits such as trading stocks. But even if you select the very best investments, you'll be hard-pressed to make up for a shortfall if you haven't saved enough. That's why setting your saving and spending rate has far more importance in the pyramid than does investment selection.

As a result of technological advances and new electronic budgeting tools, there have never been more ways to monitor and manage your spending. This is key to ensure that your savings rate puts you on track to achieve the above-mentioned goals. For people who prefer the pen and paper route, you can find budgeting worksheets online.

Note that this concept matters long after you've stopped saving, too. For retirees, the difference between a 4% and a 6% withdrawal rate can be enormous when it comes to the viability of a retirement plan. Being able to adjust one's spending rate--especially downward in times of market duress--has also emerged as a best practice in the realm of retirement portfolio management because it helps a retiree avoid turning paper losses into real ones.

Next Band: Asset Allocation

For more than 25 years, academics have been debating the role that asset allocation--a portfolio's division among stocks, bonds, and cash--plays in investment results. Specific findings have varied, but there's near-universal consensus both in the academic community and among practitioners that the asset-allocation mix you choose matters a lot. A portfolio that consists entirely of cash and short-term bonds will exhibit very few fluctuations, which can provide peace of mind and may be appropriate for very short-term goals. Over time, however, it will get eaten alive by a portfolio that includes a stock component.

Specific recommendations about asset allocation will vary by advisor and financial-services company, but the basic rules of the road should hold you in good stead during your investing career.

For your long-term goals, start heavy with high-quality stocks, then gradually shift more into safer securities as your need for the money draws near. And be careful not to gorge on niche investments such as gold and emerging-markets stocks, whose returns are sometimes explosive but so is their downside potential. Diversify reasonably among the core asset classes--high-quality stocks, high-quality bonds, and cash--and you'll be OK.

Quiz 504
There is only one correct answer to each question.

1 What types of activities form the base of the investment pyramid?
a. The most important activities for investment success
b. The least important activities for investment success
c. Broccoli and brown rice
2 What activity forms the base of the investment pyramid?
a. Selecting investments
b. Setting goals
c. Asset allocation
3 Which statement is false?
a. By quantifying each of your financial goals, investors will find that they can possible to achieve them all
b. Each goal likely carries its own time horizon, which in turn will dictate what types of investments you hold and where
c. Once you've set your baseline goals and quantified how much they'll cost, checking your progress toward them can serve as the ultimate financial checkup
4 In general, how should investors who are funding long-term goals allocate their assets?
a. In general, how should investors who are funding long-term goals allocate their assets?
b. Less to high-quality stocks and more to safer securities
c. Exclusively in gold an emerging-market stocks
5 What activity is at the top of the investment pyramid?
a. Manage your behavior
b. Manage for tax efficiency
c. Investment selection
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