Buying a home, getting married, having a child, celebrating another birthday…
What do all these things have in common? They are life changes which (possibly) require a change in your investment strategy. So even if you plan to become a crazy cat man/lady, you will still need pay attention…
In this series of posts, I will detail my reasons for choosing certain investment strategies at various stages of my life. Having the ability to recall why I chose certain allocations will help me stay the course and avoid emotional investing.
What is investment strategy and why does it matter?
You are the head chef and your investment strategy is the recipe you are aiming to follow. Your recipe (investment strategy) dictates:
- Which ingredients you use: Stocks, Bonds, Real Estate, etc.
- How much of each ingredient you use: Allocation
- How to combine the ingredients: Diversification
- How long each ingredient should be cooked: Investment Holding Period
What is an investment?
Investment is a very broad term:
- Invest $X today and hopefully receive more than $X at some point in the future.
- Invest X hours in the gym and hopefully shed some pounds.
- Invest $X in a college education and hopefully land a good job.
Technically speaking, all three of these are investments. You give something today with the hope of some reward in the future. This series of posts will focus on point one above.
What is allocation and why does it matter?
Allocation is simply the distribution of different investments in your portfolio. For example, assume I have $100 in my investment portfolio:
Allocation is so important because it directly influences the risk and return of your investment portfolio. In general, stocks are riskier than bonds – the chance of losing your money is higher. As a reward for taking on more risk, the investor must be compensated with the possibility (not promise) of a larger return.
While there are general guidelines regarding allocation, there is no perfect answer. The ideal allocation for an individual is completely dependent on their goals, time horizon and risk tolerance.
What is diversification and why does it matter?
We’ve all heard the saying “don’t put all your eggs in one basket”. This saying can be applied in many contexts, but the main point is that you don’t want your success or failure to be determined by a single outcome. So, while you may love your iPhone and think Apple is the best company in the world, it would not be wise to invest all your money into a single company. If Apple were to suddenly tank, then you would be shit out of luck.
Diversification allows us to reduce our risk, while still achieving similar returns. Diversification can be done on several levels, for example:
- Investment type – invest in stocks, bonds, mutual funds, ETFs, real estate, commodities, etc.
- Geographic region – invest in the US market and other international markets
- Company Size – invest in smaller (riskier) start-ups and larger (more stable) blue-chips
What is investment holding period and why does it matter?
When your money is invested, you cannot use it to buy that new pair of shoes you’ve been eyeing. Investment holding period is essentially how long you can live with this money being frozen/tied up/illiquid/etc. An investment holding period can range from a few seconds to several decades.
Your investment strategy will change depending on how long your holding period is. If you plan to invest your money for 40 years, then you don’t really care what happens day-to-day. The stock market could sky rocket one day and collapse the next. These day-to-day changes will change the daily value of your investment and toy with your emotions a bit, but the only thing that matters how much your investment is worth after the 40 years. The stock market is cyclical and in the long term it has always rebounded from crashes. Simply put, the longer your investment holding period is, the more risk and volatility (ups and downs) you can take on.
Part One: Young and Hungry
Date: Winter 2019
Current Age: 25
Investment Holding Period: 40 years
Outstanding Debt: $0
Risk Appetite: Hungry!
Investment Strategy Summary
What a great time to be investing! At this stage in my life I am very comfortable with taking on risk. I have a long investment holding period, no dependents (spouse/children) and no outstanding debt to pay off.
I plan to use a buy and hold strategy and retain most of my investments for the long haul (20-40 years). Therefore, my investments are centered around things that tend to produce a positive return in the long run. I also want to remain well diversified. So most of my investments are in mutual funds, index funds and ETFs. I try to select funds/ETFs with low-fees and expense ratios, as these “small” fees/expenses can equate to large sums of money when compounded over a 40-year period.
I do own some individual company stocks, but these are more the exception rather than the rule. These investments are strategic gambles and I only invest money that I am okay with losing. I can go to Vegas and gamble this money with the odds stacked in the house’s favor, or I can gamble this money in the stock market where my odds of success are slightly better.
*Alternative category includes real estate, commodities and other industry-specific investments
- Note: The target allocation percentages only consider money that is currently invested. As a result, there is no category for cash. I currently hold a reserve of cash for emergency expenses and to take advantage of investment opportunities as they arise. Check out the article “Part 1: What Money to Invest in the Market” for more information about emergency cash reserves and “playground money”.
- As previously mentioned I have a big risk appetite at the moment, so I am okay with having a very large exposure to equities.
- Alternative investments offer some additional diversification, as they have low correlation with stocks and bonds
Equities: Domestic versus International Split
- Investing in non-US companies offers some diversification on a geographical level – probably not as pronounced as in the past due to increasing globalization
- The “Golden Rule” out there seems to be 80-20 split of US-International exposure
- While the past is not indicative of the future, a 70-30 split of US-International has done well from an efficient risk/return perspective
Domestic Equities: Market Cap Split
- Diversification can also be achieved by investing in both large companies (lower risk, lower return) and small/medium companies (higher risk, higher returns)
- My strategy is already aggressive as I hold no fixed income. Therefore I feel more comfortable with an increased allocation in large cap companies
International Equities: Market Type Split
- I chose to allocate 30% of my international investments to emerging markets (China, India, etc.) as I believe these countries will make significant advances in technology and data-driven decision making
Part Two: ???
To be continued…