How you can eliminate your fear of investing with the right framework.

In my previous article I spoke about the number one thing that stops people from investing.  It is a disease known as fear.  The cure is knowledge.  I am going to provide you with that cure now.  That cure is the Investment Framework.

Imagine that its late at night and you’re walking home from dinner with friends.  You’re by yourself.  You’re tired and have to get up early in the morning.  You should never have stayed out so late but once the booze started flowing it was hard to stop.  Eventually you pulled yourself away but now you know that you really need to get home fast.

It begins to rain slightly and a cool breeze whips up.  Just what you need.  So, you decide to take a shortcut through an unfamiliar alleyway.  The street lights are out and now a mist begins to rise.  You can’t see clearly in front of you.

Suddenly at the far end of the alley two men enter.  They are both tall and athletically built.  Their trench coats drape and flow from strong looking shoulders.  Their collars are raised covering their muscular necks, just below their shaven heads.

There is a bright street light behind them.  All you can make out from the darkness are their silhouettes.  But they see you and begin moving towards you.  Primal fear begins to rise in you.  Your heartbeat increases, your palms begin to sweat.  The pupils of your eyes dilate and you feel butterflies in your stomach.  You prepare to either fight or fly.

One of the men draws closer.  He removes his hand from the pocket of his trench coat and… presents it to you.  He wants to shake your hand!  You blink the rainwater from your eyes and you realize that it’s your old barber!  You haven’t been to his barbershop in years!  That’s why you didn’t recognize his silhouette!

Fear is replaced by delight!  Why?  Because you now know who these men are!  The fearful unknown has been replaced by calming knowledge.

Believe it or now, I had this very experience.  Fear is based on uncertainty.  Humans hate uncertainty.  We hate it because it prevents us from making rational decisions.  My barber by the way is a martial arts grandmaster.  He is an expert in Tae Kwon Do. The other man is an expert in Tai Chi.  This was why they appeared so athletic and frankly, threatening.

Replace your fear with knowledge…

And so, I am going to replace your fear of investing with knowledge.  Knowledge of the Investment Framework.  With this framework you can make calm rational decisions, safe in the knowledge that you will not lose everything in the next economic collapse.

The Investment Framework

The Investment Framework covers the following aspects:

Clearly defined goals

You need to have clearly defined goals.  This is an important part of the framework. You cannot be successful in investing without knowing what you want to achieve.  For me my primary goal is saving for retirement.  Certainly, one thing to be afraid of is not being able to take care of yourself in your twilight years.  You may have different goals such as saving for your child’s education or paying for a wedding.

You also need to quantify your goals.  Put a number on them.  How much will they cost?  Make them real!  One aspect of removing that discomfort of retiring poor is to know how much you need.  Once you know this, you can plan your strategy.

What interest rate do you need to earn?

Here again the framework guides you.  Figure out what return you need on your investments.  The first step to figure this out is to look at where you are today.  How much money do you already have saved?  When do you want to achieve your goal?  How much can you afford to put aside?  Once you know this you can figure out how what interest rate you need to earn.

How much risk can you handle?

Determine your risk tolerance.  This can depend on a lot of things.  It can depend on how you’ve built your savings (i.e. where your wealth comes form).  It can also depend on how much savings you’ve already built up and if you have enough to live on (your perception of the size of your wealth). 

1. Your risk objective can also depend on where you are in the investing life cycle. For example:
   1. Are you currently in school or developing the skills that you’ll use to build your wealth?
   2. Have you begun your career and you are now investing or trying to invest your savings?
   3. Have you retired and you now need to maintain your portfolio?
   4. Or are you advanced in years and are now looking to pass on your wealth to your children
2. Depending on where you are in this cycle your risk tolerance will change. At the earlier stage you can afford to take greater risks than at the later stages.  This is because you have time to make up for mistakes and/or market crashes, etc.
   1. Most of my clients are in the first two stages of the investing life cycle.
   2. There are other factors as well such as what constraints you are under (such as how long you have before you need to achieve this goal). It also depends on how critical these goals are.  For example, having sufficient money to retire on is extremely important.  You cannot afford not to meet this goal.

What constraints do you have? 

Liquidity needs:

1. Do you have an upcoming payment that you need to make?
2. Can this be made from your income or will you have to withdraw from your savings?
3. For example, do you need a deposit for a house or a car, pay for a wedding ring, medical bills, etc?
4. It’s a good idea to keep an emergency reserve in case of any unexpected payments.

Time Horizon:

1. How much time do you have to achieve your goals?
2. This can be related to where you are in the investing life cycle but not necessarily.
3. For example, one of my clients wanted to save for retirement and also for a wedding in a couple of years. Clearly, he had two different time horizons to deal with.  One for retirement and one for the wedding.

Tax Concerns:

1. Poorly managed, taxes can have a seriously detrimental impact on your long-term wealth. It is always a good idea to check with a tax advisor concerning your investments.
2. That said, for most people, this is not likely to be a big issue unless you are a major shareholder in a company, are investing in properties or are transferring your wealth to your kids.
3. One of the advantages of pensions is that they tend to have very favourable tax treatment. Its worth maxing these out if you don’t need ready access to the money.
4. It can definitely be to your advantage to invest with pre-tax dollars and/or into tax deferred investments like pensions.

Legal and Regulatory issues:

1. These tend to be more important for institutions such as pension companies and insurance companies. These companies tend to have extensive restrictions on what they can invest in.  For example, in the United States, life insurance companies are limited in how much stock they can hold in their portfolios (typically around 20% of the portfolio).  Also they can only hold conservative bonds (no junk bonds!)
2. As an individual, your legal and regulatory constraints tend to be less onerous and harmful to your long-term returns. These primarily concern taxes and the transfer of your assets.  This is probably more of a concern to those of you with children.  For example:
   1. Trusts: these can be used to transfer your wealth but under a certain set of instructions.  For instance, you may not want to transfer your real estate portfolio to a teenage child.  So you could transfer it to a trust.  The trustees would manage the properties and provide income to the kids according to your instructions.
   2. Offshore investments: depending on where you live you may be able have your income and gains taxed in a more favourable jurisdiction (like the Cayman Islands). But make sure you are in complete compliance with the law.  You don’t want to end up like Wesley Snipes!

Unique Circumstances:

Some investors have certain circumstances that are specific to them.  For example, one of my clients told me that he doesn’t like the lack of control in index funds.  He much prefers to invest in real estate funds.  Some people prefer “real” assets to the somewhat abstract stock investments.  However, when we looked at real estate funds we found that you can find well diversified portfolios with excellent return profiles.  You can find funds that are either more or less correlated with the stock market – so real estate can provide something of a hedge to the stock market (i.e. when the stock market dips the real estate market goes up and vice versa).

1. If you think that the stock market is going to go down, real estate funds might be an option.
2. The point is here that no matter your situation you can always find an investment approach that suits you.  Never let anyone tell you that there is only one “best way” to invest.

What types of assets do you want to invest in?

1. For example, arguably the most important risk decision that an investor can make is the allocation between stocks and bonds.
2. Stocks tend to be more volatile (and hence risky) than bonds. But they also tend to have higher returns.
3. Stocks and bonds tend to be negatively correlated with each other but recently that has changed. This is largely due to the quantitative easing that the Fed engaged in after the financial crisis of 2008.  Since then, bond prices and stock prices have risen together.  It’s not clear how long this will last but quantitative easing cannot go on forever.  That said, due to the risk profile having a combination of the two is still reasonable.
4. You can also consider assets that tend to have a low or no correlation with stocks (such as gold).

Arguably, the more diversified you are, the less risk you will have in your portfolio and the higher relative return over time. Diversification is a key part of this framework.

How much can you contribute each month to your portfolio?

1. Obviously, this will be dependent on how much disposable income you have. Most people pick a percentage of their income (like around 10%).
2. If you are not constrained by your disposable income you can simply use the amount necessary to achieve your goals.
3. This will be an iterative process as you compare it with your return requirement.

Review annually!

Once you have done all this it is time to review.  You now know the following:

1. Your goals and how much they will cost.
2. What return you need.
3. You know what your risk tolerance is.
4. What your constraints are (time horizon, liquidity needs, taxes, legal and regulatory, unique circumstances).
5. You’ve decided what assets you want to invest in.
6. How much you want to or can contribute.
7. And you know to review annually.

This fundamentally is the Investment Framework.

So you simply put this all together and now you can tell if your goals are realistic or not.  This is based on the above analysis you have done.  So, one problem could be that you cannot contribute enough money to meet your goals in 10 years.  So maybe you need to extend your time horizon a few years.  Or invest in different assets.  The point is that now you know exactly what you need and you have options.  You can change your strategy if the current one is not working.  And now you have the absence of fear because you now know exactly how to meet your goals.  Fear has been replaced by knowledge.  Knowledge of how to invest and where to invest.  This is what the Investment Framework gives you.

Now I appreciate that this may all seem like a lot of work.  The framework may seem really complicated.  Maybe you don’t even know how to begin with step one!  Don’t worry.  That’s what I’m here for.  In the next article I’ll go over what you need to have at your disposal to make this work.  And after that we can get into how you can make this happen!

But if you can’t wait for that, reach out to me and tell me a little about yourself.  I’d be delighted to hear from you!