In my previous article I talked about the change in mindset that I needed to make. This change was crucial for me to become a successful investor. It led me to discover how to build an investment portfolio. This change in mindset allowed me to break through the roadblocks that were holding me back. I also talked about how I accomplished this change, so take a look at the previous article if this is an area where you need help.
Changing my mindset helped me:
- Set my investment goals
- Break through the knowledge roadblock
- Overcome my fear of investing
- And figure out where to invest.
And it will be this way for you too. In this article I am going to explain how you’re going to do it.
Don’t let fear stop you
Now if you’re like most people who worry about losing money in investments, taking that next step can be difficult. You look at investments only to be put off by the small print which stipulates that investments can go up as well as down. It makes potential gains seem not worth taking the risk.
Or maybe you still have the emotional scars of the global financial crisis. Or worse, perhaps the stocks you buy go south just after you decide to buy them. Ideally it would be helpful to have someone to take you by the hand and guide you through an approach that helps you avoid losing money in your investments. I can help you with that but in the meantime, I am going to outline how you can do it yourself.
How to invest in a way that protects your investment should the market go down significantly. And where to invest your money for the best return possible at a tolerable risk.
Determine your goals
Now the first step is to determine your goals. I have discussed this at length in previous articles. Right now, lets keep it simple and choose just one goal for now. A good friend of mine actually had a very clear goal. He just was not sure how to achieve it. Unlike me, he has been extraordinarily responsible over the course of his life.
the key to becoming wealthy is not necessarily how much you earn but how much you save
Lets call him James. James is in his mid-forties and has worked for the same company for more than 20 years. The only debt that he accrued was a mortgage and he recently paid that off. James is a regular guy and has not been paid a giant salary like some rich banker. He has simply lived within his means and amassed a good amount of savings. He proves that the key to becoming wealthy is not necessarily how much you earn but how much you save.
Retire early…
But back to goal setting. James had decided that he wanted to retire early. Ideally now (it was feasible). I counselled James that it might be more prudent to wait 10 years (until his mid-fifties) in case he suffered any emergencies that might require larger than normal payments from his portfolio. So his goal was to retire in 10 years.
Quantify your goal
Next, we needed to quantify his goal. By that I mean we needed to put a dollar figure on it. To figure this out we calculated his annual expenses now, added a small buffer and then made an adjustment for 10 years worth of inflation. How do you do this?
Assume you need $73,000 a year to live comfortably today. In 10 years, at an average inflation rate of 3.2%, that will work out to be about $100,000 per year. And let’s say that we think that conservatively speaking, you can earn about 5% a year on your portfolio. That means that your retirement portfolio needs to be around 2 million dollars.
So now we’ve put a number on your goal. I worked through the same process with James. But now we need to look at where you are today. Lets say for example you are about halfway to your goal and you have savings of 1 million dollars. And lets say that you can afford to contribute $1000 a month to your portfolio. Can we get to our goal in this case?
Well to get to a $2m portfolio with this level of savings and this level of contributions we need an annual return of about 6.3%. How did I calculate that? Well I used a financial calculator like this one.
Create your investment portfolio…
So now we need to find investments that can meet this return requirement. Bank savings accounts have negative rates (once you adjust for inflation). That means if James keeps his money in the bank he will actually get further away from his goal!
For most people, a portfolio of stocks and bonds does the job. The average return on the stock market is 10% and bonds it is around 5.5%. If we go for 60% stocks and 40% bonds James will have an expected return on his portfolio of around 8.2%. Sadly, James pays taxes so we have to adjust the return for that. If we assume an average tax rate of 30% then the after-tax return is 5.74%.
This is a bit lower than our required return. At this rate James will have a portfolio of around $1.9m. Cause for panic?
You always have options…
Absolutely not. Having discovered this issue today (and not the year before retirement) we can adjust our strategy. I have talked about the relative risk of stocks versus bonds. If James can tolerate more risk we can include more stocks to increase the return (maybe 80% stocks and 20% bonds). Or maybe James can contribute more money to his investment. Another option is just to wait one more year before retiring. Retire in 11 years instead of 10. Or maybe learn to live on less money.
The point is, if we do this analysis now we have options. The lesson is not to wait until you are retiring to figure out how you are going to meet your living expenses. Find out what you need to retire on now and then figure out how you’re going to do it.
Is it too risky?
James will want to consider his risk tolerance and the appropriateness of this strategy. Is a 60% allocation of stocks too risky for him? I spoke at length about risk tolerance in a previous article. This is important for you to consider especially if you think stocks are too risky. Or if you are afraid of making losses.
Since James accumulated his wealth passively he probably has not had much experience with risk taking activities. This would reduce his risk tolerance. Also, a time horizon of 10 years is quite short. Again, this reduces his risk tolerance. However, he already has a good size portfolio relative to his expenses. And he can afford to be flexible with the timing of his retirement. He doesn’t need to retire early. Overall I would say that James has average risk tolerance. This is subjective though. There are no hard and fast rules. Ultimately the amount of risk James takes is up to him.
What constraints do you have?
James will also need to consider any constraints he has. Obviously, his time horizon is one. Another might be large purchases that he needs to make (such as a deposit for a new home). We call this a liquidity constraint. If James needed to pay a deposit for a home, he would need to consider this in his portfolio.
Liquid assets…
He would need to ensure that he keeps a portion of his portfolio in liquid assets. Liquid assets are investments that you can sell quickly without significant loss. Bonds, gold or cash can be considered liquid assets. Real estate is an example of an illiquid asset.
What about taxes?
Another constraint is taxes. Given the impact that the tax rate of 30% has had on James’ potential return he should explore ways of investing in a tax efficient manner. What do we mean by that? Well typically capital gains (an increase in stock price for example) are taxed at a lower rate of 20% in the United States. Income tax tends to be higher. So if he invests his portfolio at the more favourable tax rate of 20% his after-tax return will be 6.6% which means he will reach his goal!
So what is the lesson here? Taxes can have a significantly negative effect on your wealth over the long-term. As such it is important to consider these in your investment strategy.
What about other factors?
Another constraint includes legal and regulatory factors. Honestly, this is not likely to be a concern for you. Regulations are typically an issue for large financial institutions such as pensions, insurance companies and banks. These may take the form of restrictions on the types of assets that these institutions can invest in. Fundamentally, an individual investor such as you will be able to invest in anything you want.
Finally, James should consider any personal or unique circumstances that may affect his investing decisions. Some people have strong personal or moral objections to certain businesses (such as tobacco, alcohol or gambling). If you invest in an index fund (which tracks a market index such as the S&P 500) you may inadvertently invest in these types of businesses. In this case, you can look for funds that focus on “socially responsible investing”.
What if James keeps his money in the bank?
Now what size portfolio will James have if he keeps his money in the bank instead of creating an investment portfolio? Once again, James starts with the same amount ($1 million). He keeps his cash in a savings account at effectively negative 2% interest. Well in 10 years’ time the value of his investment is $930,000. This is even with his annual contributions of $12,000!
This is a dramatic example of how inflation destroys your wealth! James has gone backwards and simply cannot retire at 55 years old like he wanted to. You can see clearly that the idea of keeping your cash in a bank accounts is sheer lunacy. This is why I call banks the biggest scammers around. Because while you are literally giving your money away they are either making huge profits or being bailed out by you when they make huge losses. Feel angry? You should.
Where do you find investments for your portfolio?
Now I mentioned stocks and bonds but how does one find these investments? Literally, how do you invest in stocks and bonds? Well you could go to a broker. There are many apps out there that literally allow you to buy stocks right from your phone.
Or you can go to a financial advisor. Here you have to be careful. You have to be certain that the advisor is acting in your interests. There are some very good financial advisors out there. But there are also some that just want to push products on you, regardless of whether they are appropriate for you. I have had experience of both.
I recall one financial advisor who was trying to sell me some form of disability insurance. Unfortunately for me, one of my so-called friends gave my number to her. She called me and set a meeting. Now there was nothing objectively wrong with the insurance, I just didn’t want it. But she literally spent half an hour trying to get me to buy it.
The last straw was when she tried to guilt me into buying it. By this I mean, she told me what a burden I would be to my family if I became disabled. If anyone tries to make you feel guilty for not making an investment grab your coat and leave. This is a bad sign.
Go direct!
The other option is to go direct to the companies who offer mutual funds and exchange traded funds (ETFs). Both types of funds offer you similar diversification benefits but are set up slightly differently. I’ll explain these in later articles. But generally, these funds track a broad market index, such as the S&P 500.
the biggest risk choice that an investor can make is the allocation between stocks and bonds
There are many different ETFs and many mutual funds. They are offered by companies such as Vanguard, Schwab and Fidelity. The sheer choice can make things confusing. What James did, in the near term was invest in passively managed index funds. It’s a good choice if you’re not sure. Since the biggest risk choice that an investor can make is the allocation between stocks and bonds it probably isn’t worth worrying too much about which precise fund you go for. But as I said, I will explore this deeper in later articles.
So that’s it. That’s the framework. In summary:
- Set your goals
- Quantify your goals
- Set your return objective
- Set your risk objective
- Determine your constraints
- Identify which types of assets you want to invest in
- Choose your asset allocation (the ratio of stocks to bonds)
- Calculate how much money to contribute each month to the portfolio
As I said, I will go deeper into the different assets and how they work in later articles. If you have any questions then type them into the comments section below.
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