How To Overcome Your Fear Of Investing In The Stock Market

S&P 500 Historical ChartThis post is relevant for the following people:

* Who distrust the stock market.
* Who know they should take more risk but don’t because they’ve been burned before.
* Who don’t know much about the markets.
* Who are falling behind financially every day the bull market rages on.
* Who have the majority of their assets in cash, CDs, money market and checking accounts. (See CD Investment Alternatives)
* Who want a potentially higher rate of growth on their net worth.
* Who have grown a sizable financial nut and absolutely hate losing money.
* Who have a gambling tendency.

I’ve been investing in the stock markets since 1995 when Charles Schwab had a nascent online brokerage company. My father showed me his account one trading day and I was immediately hooked by all the green and red from various stock movements.

19 years isn’t a particularly long investment resume, but I did spend 13 years in the equities department of two major investment banks. Instead of buying and holding, I was neck deep into the sales and analysis of public companies. I’d meet with senior management, travel overseas to conferences, and visit company factories to kick the tires and make recommendations.

I remember traveling 26 hours to Anhui Province, China one year. My client and I landed at 2am, got to the hotel at 3am, visited the production facilities of Anhui Conch Cement (914 HK) at 9am for two hours and then caught a 2pm flight to Hong Kong to meet five more companies. The whole process of trying to fully understand companies before making an investment was exhausting, but necessary when other people’s money is at stake. Now compare how much research the average stock investor does before buying. Kind of scary.

The stock markets can be absolutely brutal to your net worth if you are not properly diversified. If you planned to retire in 2008-2010 you were absolutely crushed if most of your investments were in stocks. Everything has rebounded five years later, but that means you lost five years of financial freedom with a whole bunch of worrying while you worked through the recovery. 

FEAR OF LOSING MONEY IN THE STOCK MARKET

When you’ve been as involved with the stock markets as I have, you see a lot of ugly. From the Asian Contagion in 1997, to the Russian Ruble crisis in 1998, to the dotcom bubble in 2000, the SARs scare in 2003, and the banking collapse in 2008, you can’t help but be a little wary of putting a majority of your net worth in stocks. Furthermore, you get to know how IPOs are sold, how hedge funds trade, how research analysts make recommendations, and how professional money managers invest their money. Nothing is exactly what it seems. If the investing public knew everything behind the scenes, I fear pandemonium would break out.

Despite all the carnage, if you had just held on to a major index fund like the S&P 500, you would have come out OK since we’re close to record highs today. Your money could have been invested elsewhere to provide greater returns since we had a lost decade between 2000-2010, but in the end everything always seems to turn out fine. It’s just hard not to feel scared when everything is going the wrong way.

When I started planning for my job exit in 2011, I knew that I had to figure out a way to get over my fear of investing in stocks because I needed higher returns to make up for my lost income. At the same time, I didn’t want to lose my shirt in the markets either. The short term solution was investing in index based structured notes which provided downside protection and full upside participation in exchange for not paying a dividend and a five year lockup.

To quantify, I’m about 50% less risk averse to investing in stocks now than just a couple years ago. Part of the reason has to do with the bull market which makes everybody dangerously feel like a genius. The larger part is because I’ve done a lot of reflection and have come up with a way to manage my risk and let go of things which I cannot control.

Several things we should realize before investing in equities (stocks):

* You never truly understand your risk tolerance until you actually have money on the line. I had a fun conversation with a friend who told me, “To not worry about losing money, just don’t worry about losing money.” Thanks for nothing. He said he had no problems losing 30% of his investments in one year, which would equal about $300,000. I then asked him whether he had ever lost $300,000 before and he said no. I have, and it’s not fun.

* It’s practically impossible to outperform the stock markets over the long run. As a result, it’s best to just buy market index funds or ETFs and save yourself time and grief. ETFs such as SPY, VTI, SDY, VIG, EEM are some popular ones.

* The main thing you should be thinking about is exposure and the proper asset allocation since you can’t outperform the stock markets in the long run.

* Sometimes you will get lucky and hold on long enough to make a fortune. There’s alway going to be the next Google, Tesla, Apple, Yelp, etc. You just have to spend time fortune hunting. Money making opportunities are everywhere.

* Even if you find the amazing opportunity, greed or fear will take over letting you make suboptimal trades. I made 60% on BIDU after publishing “Should I Invest In Chinese Stocks?” within six months. But if I held on until now, I would be up 100%. I feared a pullback that never came.

* The joke on the street is that everything becomes a long term investment once you start losing money. Holding on to your market index fund for as long as possible is the best advice for 95% of the people out there. And even the 5% of you who are investment professionals know that all this trading in and out is unsustainable.

* The saying, “It’s just paper losses” is bullshit. If you are losing money on paper, you are losing money in real life because you can only sell the investment for what it’s currently worth.

* The big boys do have more insight than we do. Wall St. sees both sides of the trade when making markets. Hedge fund manager Carl Icahn can eat dinner with Apple’s CEO to learn his vision first hand. Carl can also buy a billion dollars worth of stock and tweet to the public the very next day what he’s done to gain 8%. The solution is to simply invest along with the big boys. Buy Berkshire Hathaway stock or invest in your favorite manager’s fund if you seek an edge.

BUILDING YOUR EQUITY INVESTING FRAMEWORK

The best way to reduce your fear of investing is to construct three separate investment portfolios. If you’re incapable of constructing three separate investment portfolios, then divide your main portfolio into three parts. The latter strategy is less efficient due to the likely co-mingling of funds.

1) The Passive Index Portfolio (70% of total equities, aka “Dumb Money”). This portfolio should be your main portfolio which you count on to be there for you in retirement. For most, it’s your 401(k) or IRA in the United States. Build index fund positions with automatic contributions from your paychecks. You should certainly rebalance the portfolio at least a couple times a year to make sure your allocation of stocks and bonds is aligned with your outlook. However, treat the Passive index portfolio as “dumb money” for the most part and just let things ride. Your job is to continue contributing to this portfolio like clock work through thick and thin. (Read How Often Should I Rebalance My Portfolio?)

2) The Actively Managed Portfolio (20% of total equities, aka “Smart Money”). The actively managed portfolio is where you get to play big shot fund manager. Here’s your chance to discover your investing prowess or lack thereof. We’ll certainly get lucky here and there, but I’m pretty sure most of us will underperform the S&P 500 over time. After a while of spending all those hours researching stocks and funds and sweating pullbacks, most will gradually realize their time could be better spent doing something else. As a result, there’s a natural trend for our actively managed portfolios to turn into a passive index portfolio over time. (Read How To Better Manage Your 401(k) For Retirement Success)

3) The Punt Portfolio (10% of total equities, aka “Unicorn Money”). The reason why it’s better to have a completely separate Punt Portfolio is our tendency to steal cash reserved for our passive or actively managed portfolios. You’ll also be able to calculate your returns much easier. The Punt portfolio is where you actively pick stocks and go for broke. You go all in on JC Penney (JCP) at $5.5 hoping for a turnaround instead of a bankruptcy. You buy SINA stock down 20% in a couple weeks due to fears of Chinese ADR delisting due to accounting issues. You buy NFLX at nosebleed levels because House Of Cards season 2 is going to be a massive hit. Your punt portfolio throws all risk management out the window. I have no problems dumping 50% of my entire Punt Portfolio into one stock.

My three portfolios are at three different institutions so I can clearly see performance and not co-mingle any cash:

1) The Passive Index Portfolio is with Citibank Wealth Management where I methodically contribute 80% of my savings every month into an existing index fund holding or new structured note based on an index.

2) The Actively Managed Portfolio is with Fidelity where I can no longer contribute since it is a rollover IRA. But I did start a SEP IRA through my business. The reality is my rollover IRA with Fidelity has been acting more like my Punt Portfolio recently, but I’ve decided to be more balanced with the way I invest.

3) The Punt Portfolio is with E*TRADE where I whip it around like a gambler.

PSYCHOLOGICAL ADVANTAGES OF SPLITTING UP YOUR PORTFOLIOS

A lot of investing is mental. It’s all about trying to hold on for as long as possible without getting wigged out by some correction. After you’ve accumulated a certain amount, your mindset shifts from growth to capital preservation.

1) More protected from disasters due to different investment strategies. It is unlikely that your three portfolios all have the same investment strategies. For example, you could be actively hedging with your Active or Punt portfolios because you feel the markets are overbought. Or you could have gone 100% Treasury bonds in your Passive portfolio, thereby protecting 70% of your overall investments from a downturn. Diversification saves investments during downturns.

2) You’ve got more hope. Even if you have false hope, creating multiple portfolios gives you a much stronger belief of long term survival. It’s like having multiple engines flying an airplane. If one engine goes down, you’ve still got a good chance of landing safely with the other two still functioning. If you’ve ever seen big cash game poker events on TV, you’ll see competing players ask each other if they’d like to “run it twice” or even more. Even though the odds are the same, there’s a tendency for those players who are more risk averse to ask. When you have more hope, chances are higher you’ll continue to methodically invest more money in equities.

3) You start accounting for worst case scenarios. The biggest fear I have for investors today is unbridled enthusiasm. According to one recent survey from consulting firm EBRI, 25% of people over the age of 50 had 80% of their holdings in equities and 30% had 50-80% of their holdings in equities. It’s as if we’ve forgotten about 2008-2009 already. The historical average equities allocation is 60% according to AAII Asset Institute, which also reports that the average is up to around 63% now. By running multiple portfolios based on passive and active investing methodologies, you naturally start to segment your risk by thinking about worst case scenarios for each portfolio. You then invest accordingly.

4) Easier to invest large sums of money. When you’ve only got $100,000 to invest in the stock market, it’s not that hard to buy 10, $10,000 positions to build your portfolio. But if you’ve managed to build a $1,000,000 portfolio, it gets a little more frightening to invest $100,000 in each stock or fund for example. Those who fear investing larger sums of money tend to be those who’ve managed to keep lifestyle inflation at bay. By splitting your $1,000,000 portfolio into $700,000, $200,000, and $100,000 portfolios, you trick yourself into making sure you’re investing in your recommended allocation in equities. Let’s say your recommended allocation is 80% equities, 20% bonds – it’s easier to invest $560,000, $160,000, and $80,000 in equities and $240,000, $40,000, and $20,000 in bonds in your three portfolios instead of $800,000 in equities and $200,000 in bonds just in one big portfolio. The results may be the same if you invest in the exact same securities, but the point is you’ll be much more inclined to execute your positions with smaller amounts of money. Besides, your investment strategies will be diversified going back to point #1.

5) Easier to assess risk and invest more clearly. If you’ve got one portfolio that is carved out with multiple investment strategies, it’s much harder to ascertain the overall portfolio’s risk composition and performance, especially if you are rebalancing often. By creating different portfolios, your analysis on risk and returns becomes much cleaner. An easy way to screen portfolios for appropriate risk, performance, and cost is through Personal Capital’s Investment Checkup tool. It’s located under the Investing tab on the top right of the homepage. Make sure to click the drop down arrow on the almost top right after you are in Investment Checkup to go through your individual portfolios one by one.

BE IN IT TO WIN IT

If we keep most of our assets in cash or CDs, we are falling behind unless we’ve got outsized income. I strongly believe in the two parts offense (stocks and real estate), one part defense (CDs) to build financial wealth over the long run. Bull markets are a net negative for the middle class because the top 5% own more than 70% of all assets.

The ideal scenario for the average person is to experience another massive downturn, hold onto their job, and deploy all liquid assets into the markets to catch an inevitable recovery. But we know thanks to fear, this will never happen, so quit saying you hope for a meltdown to invest more in stocks and just stick to a regular contribution system.

Although stocks have shown to return roughly 8% a year over time, I’m always going to have a wary view of the stock markets because of my experience. It’s like the chef not wanting to eat too much of his own food because of all the unhealthy ingredients that went into making his dish. We just need to make hay when the sun is shining. Eventually a blizzard will come for us all, at which time our defensive shields start kicking in.

Related Reading:

Recommended Allocation Of  Stocks and Bonds By Age

Recommended Allocation of Net Worth By Age

Readers, how do you overcome your fear of investing? If you are underallocated based on what you think you should be allocated, why do you think this is? What makes you distrust the stock market and how do you think the markets can regain investor’s trust? For those with portfolio sizes above $500,000, what are some things you tell yourself during downturns?

Regards,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Dividend Growth Investor says

    That’s a good article for those who are afraid of stock market fluctuations. I agree with most of it except for this quote from the article:

    “The saying, “It’s just paper losses” is bullshit. If you are losing money on paper, you are losing money in real life because you can only sell the investment for what it’s currently worth.”

    I think that if you do not need to sell, you should ignore the pain of short-term market fluctuations. This is easier if the stocks you own pay you dividends in cash, which you can live off and ignore the noise of the markets. After all, you are investing for the next 20 – 30 years. That makes it much easier to hold on to your stocks, and remember these dividend stocks are shares in actual businesses you are a part owner of, not some lottery tickets.

    Actually, Charlie Munger has a really sweet quote about investing in the stock market:

    “In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

    • Mr. B says

      I thought your whole thing was trying to retire early? I think you should very well care about your portfolio going down a lot of this is the case.

      When did you start investing seriously and have you ever seen a down market?

    • says

      I love quotes from hundred millionaires and billionaires :)

      It’s easy to say “stick with it” during good times. It’s totally a different case when the markets are indeed crashing 50%.

      As you’ve just recently started investing, I highly recommend you not have 100% of your net worth in stocks b/c if stocks are crashing, job risk also heights, and dividends tend to get assaulted.

      It’s hard to explain a downturn if you’ve never been in one, but all I can say is trust me. Diversify!

  2. Austin says

    My largest revelation was in using option strategies to generate income and hedge downside risk. Buy a put sell a call. Nothing too risky.

    I wonder what the real world effect of the short sale Rule 201 is. Seems to me that markets are collared by law now. Still, HFT scares me. Knight Capital is an excellent example of the insanity.

  3. says

    I like that Munger quote above.
    For me, I try to also find companies that are paying me cash dividends and will be able to continue doing so at an increasing rate for a long period of time. Personally, I like these dividends even more than stock buybacks.
    This is a good primer/list of things to keep in mind for folks who have been afraid of the markets. Thanks for sharing your own fears about the markets.

  4. Mark Ferguson says

    I have taken care of my distrust for the stock market by investing in rental properties! I still invest some of my IRA in the stock market, not much at all.

  5. Ravi says

    I started putting significant money into savings/investments in 2012 when I took my first job, so I’ve been much more focused on how much I save rather than how much I earn since then. Now that I’ve crossed $100K in investment accounts (sum of 401K, brokerage, etc), allocation may start to become more important going forward than it has been up until now.

    Like you said, it’s easy to feel like a genius in a bull market. Almost any Vanguard index fund (large, small, mid, whatever) returned 20%+ in 2013, but I definitely do not expect more than 10% per annum in 2014-2016. In fact, I’m expecting either a relatively flat market or even a drop in this time. It will definitely be more stressful once I have holdings in excess of $500K, since daily swings cancause gyrations of more than my paycheck!

    Since I’m so early in my career, a drop in my portfolio would be a bit disheartening… but on the other hand, when else do you get to buy up cheap assets than in a downturn? :)

  6. says

    I see it all the time with younger people who are afraid to go 80-90% stocks because they don’t think they can handle the risk. If you’re under 30, you’re looking at a 40-60 year investment horizon. If stocks don’t go up over that long of a time period, I think we will have much bigger issues on our hands.

    I don’t even look at the markets anymore b/c there’s no point. I see my balances going up and down but I’ve even considered to stop tracking those.

    • says

      Care to share your balances?

      I just read over the weekend that the Millennial generation is investing like the Depression generation somewhere.

      I can’t blame anybody for being conservative. I’m conservative, and my point of this article is to not miss a massive secular bull market if we are indeed in one by having some participation.

  7. says

    I agree most people should have the vast majority of their portfolios in index funds as most people get too emotional over the swings and make bad trades. I’ve read countless blog posts and comments over the past few months about people “waiting for a pullback” to put more money in the market. I wonder how many people actually ended up doing so over the past few weeks.

    • says

      I’ve actually pulled a little more back out of the market, due to a sell order I had in for RTN that was triggered recently.
      I enjoyed the ride up by 26% on some shares (bought them at a low of $76) and 6.6% on some others.
      I may just set some very low buy orders just to see if they get hit. That has served me well over the past 4+ years so far, along with buying/selling within a range several times a year. Primarily I work with the dividend paying stocks but use the dividend as a hedge against any stock depreciation and sometimes until it recovers to break-even (not counting dividends).

  8. nbsdmp says

    Don’t quote me on this, but I believe that it is somewhat factual that if you missed out on the top 20 days in the last 20 years in the stock market you would have missed 80% of the gains. I am one of these people who is fearful of the stock market because I truly don’t understand how some companies can be considered so intrinsically valuable that they can trade at such high values. I do believe though that you have to be in the game.

    The one thing that is not covered here is what percentage of your overall net worth your portfolio should be…and also how you should rebalance that ratio as your NW and age increases. I agree with one of the commenters above…if the whole thing is not trending upwards we all have bigger issues to worry about than portfolio performance!

    • says

      You might of missed the last section in the post highlighting two related posts:

      Related Reading:

      Recommended Allocation Of Stocks and Bonds By Age

      Recommended Allocation of Net Worth By Age

  9. David Michael says

    Another great article. Thanks.

    Now, looking back at “woulda, coulda, shoulda” of my prime working years, here is my own experience regarding investing.

    All of my fellow teachers (first career in community college in the SF Bay area) who are wealthy today made their fortunes by investing in real estate, one house at a time (starting in the period of late 1960’s). Then to a duplex, and a fourplex according to one’s desires. Nearly all are multimillionaires today in addition to earning a handsome retirement from the state.

    To be honest, I wanted to do it my way by investing in world travel as my source of wealth and life experience. My fellow teachers begged me to buy an extra house or two in addition to our own which went from $37,000 to 2.5 million in Los Altos, CA. Of course we had moved way before it reached the million dollar level. I hated the dense population of California and the traffic and freeways. And I didn’t want to be a landlord.

    I did invest in the markets to make up for the differences, trading stocks, options, whatever, you name it, I did it. Over thirty years it was a complete disaster…because I wanted the action and always thought I was smarter than the market makers. My guru was Nicholas Darvis of “How I Made $2,000,000 in the Stock Market” fame. I did make it around the world many times, trading as I went, but never could keep the profits growing as he did. Alas…I found Warren Buffet was right all along. Keep your stocks or mutual funds forever.

    At age 77, we have balanced out our losses with IBonds (which return a steady 5% which we bought 12 years ago), working seasonal jobs, and living modestly still travelling around the world in retirement. Our big nest egg for retirement was the annuity which went belly up in a company bankruptcy. So, in short. Yes! Diverisfy, diversify, diversify. Hold your mutual funds forever, and balance them out with a sure thing such as CDs or cash or IBonds. Now we are investing monthly in P2P Lending. That’s going well. But…the winner is (IMHO)… REAL ESTATE. (And…Social Security for those who screw up along the way.)

    • nbsdmp says

      Wow David, great contribution there. I have to say I 99% agree with you…I’ve been fortunate to create a nice nest egg. I have very little desire to put more “new” money towards the stock market and fee based investments. Yes a diversified portfolio is great to have, but it does not give me the same feeling of financial security that paid for income producing real estate does. I’ll keep maxing out the 401K, but distributions and bonuses are going into tangible tax advantageous income producing assets like real estate and small private businesses.

    • Sunil says

      Great perspective. We live in SF bay area and the story has not changed much…. well except that Los Altos/Palo Alto area ceased being middle class long time ago. I invested heavily in real estate between 2009 to 2012 and within a short span our net worth has shot up to close to 1.3 million. The rental market in Bay Area is so crazy right now that are people are overbidding on rent. Couple months back I had put out one of my condos in Sunnyvale for rent. I was asking slightly below market rent and I was flooded with response and ended up renting it $300 over the asking rent!! I also think real estate is the way to go for huge gains because of the leverage involved. A 20% rise in value equals 100% ROI (with a 25% DP). Plus someone else is paying your debt! You just cannot beat that… I also dabbled into stock market after almost a decade (after losing a fortune during the dot come debacle). I actually shorted the market back in 2007/2008 via inverse ETFs which were brand new products at the time. While I did make decent money it was lot of work and stress. For example I was doing great with this inverse ETF called SKF and suddenly TARP was declared and Fed temporarily banned naked shorting. The market shot up and instead of being 15k up I was 25k down. It was very stressful and I got out. Which in hindsight turned out to be a wrong decision because market after a short burst tanked another 20%. Oh well… I think if you have a long enough time horizon index funds are the best. The strategy is not sexy but it works… It also pays to invest in an asset class that’s hated by everybody. Currently that asset seems to be gold. Most of my investments for this year are going to be in gold. I could be wrong about it but buying gold now as compared to 2011 makes sense. What is your opinion on gold Sam? I dont think you have ever done an article on gold. Would love a piece on gold from you.

    • says

      Great perspective! Thank you. Real estate is my favorite asset classes partly b/c I don’t have to constantly monitor and look at it. It’s almost like waking up 10 years later to see the debt lower and asset price higher.

      What do you think of your social security checks btw? Gravy? Thankful? Funny money?

      • says

        Hey Sam,

        Playing off this tangent of real estate investment, I have been giving serious consideration to REI before even buying my own place or investing further in the stock market. The hesitation I have though is that living in Cayman, the monthly maintenance, sewage and insurance costs coupled with property management fees basically means that even with a downpayment of 33% on a $500k condo (which usually equates to 2br + 2ba) you basically just break even. The argument though can be made that since I would be looking at this as a long-term investment, once the mortgage is paid off (which I would attempt to do in 5 years), that becomes a pretty stable income stream.

        I’m just not sure if it would be the best use of my money or if I should look into investing first in cheaper real estate, perhaps somewhere in south florida where I would be able to buy a condo with very little financing, if any/

        Thanks

  10. says

    I’m basically always all-in because I’m not willing to pay for a reduction in portfolio volatility by way of reduced returns. I stay in the market and diversify globally.

    But then again, I invest for the long-term. Of course, a retired couple with a joint life expectancy of 23 years is also ‘long-term’. Heh.

    Heck, we’re probably in a cyclical bull market that just might come down to earth a few years in front of the end of a secular bear. Talk about opportunity… If that’s true, Katy bar the door. If not and we crash and burn I’m more afraid of missing the run up after a major correction than I am of of losing more money.

    • says

      Being afraid of missing the run up vs. not being as afraid to lose money is a very interesting mindset.

      I think once you find what’s ENOUGH for you, then you no longer fear missing the runup b/c you’re already satisfied with what you got. Besides, everybody to some degree rises and falls with the markets.

  11. mysticaltyger says

    I still think an actively managed balanced mutual fund is the way to go. Behavioral finance tends to find that people stick with balanced funds for longer and get better returns from them than 100% stock funds. Results have also been good for target retirement funds. Some of the best balanced funds have actually beaten the S&P 500 over the past 20 years, and many others have come close to beating it with less volatility, such as:

    Oakmark Equity and Income
    T. Rowe Price Capital Appreciation
    Dodge & Cox Balanced
    Mairs & Power Balanced
    Vanguard Wellington

    All of the above funds have below average expenses (almost index-like in Vanguard Wellington’s case) and have beaten the S&P 500 over the last 20 years with less volatility.

    • says

      Those are some great and famous funds. I’ll definitely have to revisit them.

      I’ve got several friends at Dodge & Cox based right here in SF at 555 California and those guys have it GOOD. Private firm, $200billion AUM+ and not many people. They are killing it. Perhaps this is why I don’t invest too much in actively managed firms. I see the people behind them make enormous sums of money which could be used to boost shareholder returns instead. Maybe not!

      Oakmark Equity and Income
      T. Rowe Price Capital Appreciation
      Dodge & Cox Balanced
      Mairs & Power Balanced
      Vanguard Wellington

  12. Ace says

    Sam,

    I like your portfolio thought process. Actually, my thinking is very similar.

    I would like add a few thoughts in regards to folks whom are heavy real estate investors. If you are big into real estate; you are already taking on considerable risk. Real estate is kind of a beta plus (leverage) type equity investment, and includes very high liquidity risk. Well….. Actually, there is a long list of real estate risks, because of the continuous outflow of cash involved; from vacancy periods, to insurance companies not paying claims, to unexpected repairs, to earth quakes, etc.

    Diversification is all about owning uncorrelated assets. If you own a lot of real estate, you need to balance this liquidity/cash flow risk with a much greater cash or cash like reserve (T-Bills, CDs, etc.). Also, you may want to be a bit more limited in your stock investing.

    Also, the same could be said for folks who are small business investors (such as myself). You already own equity, if you own a small business or businesses. You need to diversify into other things.

    • says

      It’s hard to find truly uncorrelated assets, but bonds and cash will generally have to do. I dumped a chunk of change into MUB, a muni bond fund ETF last month, and REM. Fingers crossed rates don’t rocket much again. Maybe I should take my profit and run.

      • Ace says

        Ok Sam, here is a thought which is outside the standard investment advice box.

        Diversification really only works with uncorrelated things. Just buying an index is fine in regards to eliminating unique risk (risk related to a specific firm), but this is not true diversification. An economic disruption will cause the entire market to collapse, and correlations will approach 1.0.

        I will offer an anecdotal view point. The people I have encountered, whom have successfully transitioned from lower middle/middle class to upper middle/upper class, have all done this through some kind of small business ownership.

        I have great admiration for the small business person. My folks were successful small business owners and they only had an eighth grade education.

        Growing up, I remember being surrounded by my parent’s friends, whom were basically all small business owners. Some doing extremely well; most doing ok!

        The way to wealth is through the ownership of a good business with solid cash flows, which could be passed along to your children, or sold for a good price. The nice thing is, no matter where you live, there are small business opportunities.

        But let’s say you are not interested in jumping into self employment. Maybe you have a great career with a solid corporation. There is always moonlighting; but not everybody has the energy or interest in such activity.

        Here is my thought: Concentration…… Do some research. Find four, five, maybe six solid companies which have great brand names, have been around for ever, usually have good dividends. These should be firms which have products or services which you are personally familiar with (and preferably use). Buy these firms. Slowly… Over decades. Reinvest the dividends. When the market offers these stocks at a discount; buy more! Don’t ever sell. These will be your investment core. Your own “personal business ownership” using publically traded stock.

        Think about this. Over a lifetime, owning a GE, a MacDonalds, etc. These are brands which always retain value. Owning a large concentration of these kinds of stock will make you wealthy. And it’s a very simple concept which anyone can do.

  13. Ace says

    Yes…. Cash is always the neutral position. Treasuries frequently have a negative correlation to equities.

    I know your goal is to keep things simple, but I tend to like using options as a way to gain exposure with very limited risk. This obviously takes more education/sophistication.

    Best thing…. Always think balance! Balance risky assets with risk free. That would be a simple rule!

  14. says

    This is a macro question.

    More than a few pundits are forecasting deflation over the next 10-15 years as baby boomers retire in larger numbers thereby pulling down their purchasing/investing power.

    Do you have an opinion on this as it relates to this post and outside of it as well?

  15. says

    I got over my fear of the stock market the moment I realized that my only hope of breaking through the middle class would be to take risks and make my money work for me.

    I started investing right out of college and was excited when I put my first $2,000 on the market. I’ve gotten a steady ~30% each year in addition to the money I inject every quarter from my savings. My stocks started with AAPL and XOM, then pure AAPL. I then sold that in order to get in on NTFX after they dropped down from high $300s to low $100 following their price hike announcement and services split. I was a NTFX customer and felt that the changes were reasonable and thought everyone was overreacting. Unfortunately, as Sam explains above, the average investor does not have the full picture. So I was a bit shocked when not long afterwards NTFX dropped another 50% after a PR debacle regarding a rebranding initiative for their DVD service. Even though I didn’t have much capital on the market, it was a shock to see such a drop. Literally -50%.

    Now, I know they say you shouldn’t double down, but that’s exactly what I did. Why? Because I felt that the company offered an unbelievable service. I was receiving high-quality entertainment, straight to my home for less than $10/month. And the flood of competitors on the market were laughable. Amazon’s experience is no where near as smooth and Hulu has nice technology, but clutter it with commercials (even if you pay). So I kept with it. A few months later they rebound, but they are still hemorrhaging membership in the U.S. (down 1 million subscribers), so the stock once again drops down to the low $60s. Still, I persist. House of Cards is announced and growth in international markets is on the rise. As NTFX recovers, I sell at around $130, earning a solid 20% gain.

    I buy into AAPL, ride it up a bit and earn another 30%. Then go back to NTFX in around $107. After a few weeks of disappointing market movements, they release blockbuster quarter results that turns everything around. Here, again, is where Sam is spot on in regards to stock market. No matter how much confidence you have or how experienced you are, you can’t ever seem to buy or sell at the “right” time. The stock shot up 30% on the earnings report, I was ecstatic and happy with the return. A mere 12 months later NTFX is pushing $400.

    Had I held onto my conviction that NTFX was worth all the $300 and more during its peak, I would have reaped much higher rewards. Regardless, this is a story of success not failure. Success in that even though I did not win as much as I could have, I still came out ahead and have since moved on to my next stock. This time with a bit more risk, and hopefully with a bit more force of will to endure the ride to the top (if it comes).

    • says

      I hope you are talking about NFLX (Netflix)!

      I love your line, “I got over my fear of the stock market the moment I realized that my only hope of breaking through the middle class would be to take risks and make my money work for me.”

      Now that’s what it’s all about. Taking ownership. Taking risk. Realizing nothing will be given to you and that you’ve got to go out there and take it.

  16. Ap999 says

    Great article! I’m 29 and I’ve been the indexer type passive investor, I’ve enjoyed this bull market. I’m slowly increasing my stock exposure more and more. Currently I have 30 percent fixed income and 70 perecent stocks. I’m planning to leave fixed income alone, I have enough in there that I feel comfortable for more stock exposure. I was not heavy into stocks during 2008 down turn, I was about 23-24 years old with an IRA that had about 9000 dollars in it, and I saw it go down to about 5000 dollars or so. But since at that time 9000 didn’t feel like a lot to me I didn’t pay too much attention to it. I knew I was in the market for at least another 30-40 years so it didn’t matter too much in the long term. Now that my net worth is upwards too 340k I feel I want to protect a little more. At this level I sure would feel more hurt to see it plummet it 40-50 percent. I sure hope I do have the discipline to stay in should we see another 2008.

  17. KG says

    Nice post! I personally overcame my fear of investing in the stock market when I was 18 — right when the stock market crashed in ’08. I’m an entrepreneur, and I figured this was a great opportunity to step in, because I knew the stock market wasn’t overvalued at the time. Since the crash, I invested in Google, Apple, Netflix, and a bunch of Vanguard funds.

    Here’s where my question for you comes in…

    I run my own online business in the electronics niche. This combined with $200k made from investing has given me a net worth of over $800k. Currently, about 60% is in stocks, 30% in business inventory, 10% in cash.

    I recently got married and my wife and I are talking about possibly buying a house sometime in the future. But housing prices have spiked in Orange County, CA, where we live and plan to stay. In fact, Trulia lists it as the #1 area in the country where housing prices are in a bubble. This makes me a little reluctant to buy a house right now. Inventory is also very low at about 1/3 of historical levels.

    The other issue is that, although I work from my apartment currently and can live anywhere, I don’t know for sure what the future entails. If my business were to fail and I had to get a job, I may want to be in a different area — although I’ve narrowed it down to a few good central areas.

    My gut tells me that these are the three best options:

    1) Wait a few years and buy a house in cash. Advantages: housing market may settle and inventory may rise, and I may have a better idea of what area I need to live in.

    2) Buy a house as soon as possible with a mortgage. Advantages: can take advantage of low mortgage rates and write off mortgage interest on taxes.

    3) Rent forever. Advantages: avoids real estate bubbles, avoids CA’s 9.3% capital gains tax, and I can invest the difference in stocks and enjoy a historically higher rate of return in stocks

    What do you think? Thank you for your advice :)

  18. says

    I have a basic distrust of the stock market! Although I love seeing my stocks and funds increase, I wonder why it occurs for no reason. There was no earnings or news, but the stock or fund goes up or down. It reinforces the conspiracy theory of a lot of inside information. One of the ways, I balance this distrust is to look for stocks or funds that can zig when the market zags. I invest in healthcare, technology and biotech to balance the traditional asset allocation. It fits with my growth goals too.

  19. says

    I was a poker player before I ever picked up a book about investing. So risk/reward was abundantly clear to me, I believe the reason most people are scared of the stock market is because they lack the proper education on understanding what the stock market actually is.

  20. DJ says

    I agree with some of the points above, and most of the points in the article; I have some strong reservations about the stock market, but they have more to do with market structure and HFT than anything else. Sam, you made a comment about having a harder time investing in the market because you know what really goes on behind the scenes- I am in the same boat. I traded the market successfully for years; I have the dubious distinction of having both made and lost $50K in one day of my own money, and I have made up to $150K in one week, but have also lost $100K. One thing I will tell you- losing $5 or $10K is much easier than $50K- being long TZA and SPXU on the day they announced a repo in late 2011 was a real nut-crusher- made $90K in one week, but then lost $50K of it when the market ripped upward the following Monday. Now that I have gotten a little older, I simply don’t have the patience, time or stress tolerance for it- paying somebody to do it for me (RIA/fiduciary firm) was the best thing I could have done. There are a couple very positive things to be said for long-term buy and hold- tax advantages, and you don’t have to worry about an algo jumping in front of you on every trade, lol; HFT has gotten completely out of hand (the term “rigged casino” comes to mind). If you want a good read- check out what happened to Knight Capital, and also check out Nanex on a regular basis- it is an eye-opener to what is really going on.

    I have started and sold several different successful companies- there is plenty of risk in having your own company; loss of investment capital, lawsuits, employee issues, tax issues, etc. are fairly common, even if you are a seasoned businessman/woman- you name it, I have dealt with it over the last 18 years. I think having your own business is a good way to elevate your net worth and can be very rewarding, but many people aren’t cut out for it (completely understandable)- you have to be able to juggle, problem solve, and it can often take you away from the original reason that you started the business (love of a certain field). The more money your business makes, the more that you get away from that love (at least I have)- it is an odd paradox….

    Real estate is cool (I have my own holding company as a side/passive entity)- liquidity and leverage risk is always there- the gentleman above had some good points. Cash-on-cash leveraged return is pretty phenomenal with RE, but it can be a double-edged sword if you get in over your head and don’t have proper reserves. Buying from distressed owners is one of my favorites (goes back to people getting in over their heads), as it allows you to capture appreciation on the value of the property as you renovate, and also generates really good cash flow. Picking up a 13 or 14 cap project and selling at an 8 or a 9 cap value with the renters paying for everything outside of the DP- pretty good deal IMHO…..

    So what do I do? Spread it around- I keep 25% of my NW in stocks/mutual funds (spread around the world- my firm uses DFA, but Vanguard, etc. is fine as long as the fees and turnover is low), 40% in RE, 15% in bonds/T-bills/CDs, and 20% in cash (you never know when a bargain comes around)- this is on a NW that is a little shy of $3M. Outside of my RE holding co., I don’t have my own business for the first time since 2002 (sold my last company in 2012). I have to admit working for someone again is a little weird, but it is a relief and is much easier in a lot of ways. I still have 2 years left on a 4 year NCA, and once it is up, I will be back out on my own- I am really looking forward to it…..

    • says

      Sounds like you are swinging some LARGE positions DJ!

      Did you have a nice windfall on selling your company? How long did it take from conception to sale? I’m fascinated with entrepreneurship, but I’m finding more and more that it’s hard to get really rich selling a company due to so much dilution.

      • DJ says

        Ugh on the large positions- learned a valuable lesson about concentrating assets. From what I have learned over the years, diversified individual stocks and ETFs from around the world are best (these are where I had my best returns), and stay away from levered index funds (long and short), because algos will torch you. Better to hedge long positions buying puts than to hedge using inverse funds; another important thing to remember- long-only works great in a certain climate (bull), but to stay long-only in a bear gets really tough. It has to be looked at as a buying opportunity, but if you are all in with stocks with no cash set aside and no assets to shift around, this opportunity will never be realized. Don’t try to guess when the market is going to flip, either- it doesn’t make any rational sense, as QE distorts everything- you can’t fight the Fed. Another thing that has worked well for me is shifting/repositioning assets when one class gets to big- there are always opportunities to make money (especially if you already have it), but you have to look.

        All my companies have been in the health science field; sale price price was mid-seven figures- this one took around 5 years to develop, build, shop and then sell. On the dilution end, depends on who you partner with (banks, investors, etc.) and how much the debt load is; this last one I started with a $30K investment of my own funds- pretty good return on the sale, plus it paid me a $100K plus per year salary in an area where it is not very expensive to live. I didn’t take on any outside money (good margins/cash heavy biz), outside of a revolving LOC that I never really tapped; taxes were all cap gains because of the corporate structure and holding period, and I sold for two reasons:
        1. I can put the same type of entity together again in a quarter of the time
        2. The small business climate in the US is going to really suck for the next 3 years, which coincides nicely with the end of my NCA

  21. marcel says

    Hi Sam,

    I feel very similar about stocks as you do having experienced all those major downturns you mentioned. I stopped picking stocks a decade ago and only invest in funds, although I am seriously confused right now with individual stocks looking like the place to be again. I remember one financial advisor saying we should consider our real estate allocation similar to our stock allocation, in that they are both high risk. Hence my allocation right now.

    35.89% SF condo – yielding about 4% – considering selling if 2014 stays strong
    8.12% Punta Cana condo – living there now
    38.48% Cash – this seems to be the amount I need to be able to sleep at night
    8.53% Stock funds – about 1.5% yield
    5.19% Bond fund – about 2% yield
    3.80% Punta Cana restaurant – about 25% yield

    • says

      Id just keep your property forever frankly if you can. Check out my post on When To Sell Property in the archives.

      35% cash is a lot, but whatever makes you feel comfortable is important. Although, if you are cash flow positive, you can probably do fine with 5% and reinvest the cash elsewhere.

  22. says

    Awesome article. Investing can be hard though, and I’m not talking just about the valuation of companies or finding intrinsic value. I love reading Graham, Munger, Buffet, Siegel, Damadoran, and the like, but I still find myself having to calm my irrational thoughts and fears. I can only do that because of my education on the subject, and knowing that dips or corrections or crashes just provide another buying opportunity. If the average person doesn’t educate themselves on the subject, they will be hard pressed to overcome their irrationality.

  23. says

    Hi Samurai,

    everybody says: “Dumb German Money”

    The Germans have much fear of the stock market!
    But why?
    Because they buy when the market is high (because all buy).
    And because they sell when they make losses.

    I always say to my friends:
    Stay cool – and buy, if the markets goes down!
    Than forget your shares and look next year in your portfolio again! ;-)

    Best regards
    D-S

  24. Kyle says

    Another Great Read.

    I would love to see a post about how you think people in their early 20’s to early 30’s should be investing right now.

  25. MD says

    Sam,

    I use the bucket strategy. My first bucket is money that I could need within 3 years. All this money is in a high yielding (well as high as we can get nowadays) money market.

    The second bucket is in bonds. Today that means short-term, high grade corporate bonds. I use a very low cost mutual fund. This bucket is for years 3 to 7 of spending.

    The third bucket is my equities – mostly very low cost index funds (I use VTI as well), broadly diversified with 1 active manager that I have use for 16 years and about 5% of this money in what I call “my delusion that I am the next Warren Buffett” lunacy. I do employ a tactical model though. As the TTM PE increases, I take 5% out of this bucket and put it back into the second bucket. I have certain markers and once the market valuations go past these markers, I decrease my risk. Today, I am 10% protective. As the market goes down, I do the reverse. Caution – this all goes out the window during a scenario like 2008 when corporate profits crater and PE’s shoot through the roof. At that point you cannot sell. You need to grin and bear it and wait for the recovery.

    This method helps me sleep at night and gives me decent exposure to the equity markets.

  26. says

    I beg to differ. There’s a reason most people lose money in the markets. They lack are a proper education and a trading system for markets – all markets, and the discipline to follow a system. Your brain isn’t wired to win in the markets. You have to “learn” how to win. Learning how to trade is like the plot in the new Tom Cruise movie “Edge of Tomorrow”, where Cruise’s character gets his butt kicked because his enemy knows what Cruise will do before he does it. Cruise had to wise up and devises a plan of attack. He had to “learn how” to win.

    When properly trained, (granted, the vast majority of market participants aren’t properly trained), and you have a real battle tested trading system that you understand and follow, you can easily outperform the market. And when I say “trading system,” most people think of some “general rules” for trading. That’s not a system, not even close. Having a trading system tells you what to do for every market scenario. It’s a guidebook, a roadmap that covers every detail, every aspect of what could go wrong, and how you are supposed to handle it.

    Every successful business has a system (guidebook or roadmap) to help their company excel. Think McDonald’s, Starbucks, Apple, the U.S. Army, and the NFL. If you are a new recruit, officer or enlisted, the Army hands you its guidebook on day one. You are instructed to study it cover to cover. If you are a rookie to a new football team, they hand you their offense/defense guidebook of their plays. You are expected to read it, study it, and know it cover to cover before you get to put on the uniform and play. McDonald’s has Hamburger University. When it comes to the market, everybody thinks they can wing-it. They can go with their gut or instincts. They think they can win based on rumors or win based on what pundits say on TV. Trading is a business. You need to treat it like one. As far as not beating the market averages; No NFL team will ever admit they are just average or they cannot beat the best in the league, but this is the general attitude in the markets.

    You can make money when markets crash 50%, like it did in 2008. In fact, you can win big when markets are crashing. Yes, you can outperform the markets, with regularity. It starts with an education, a trading system and discipline, all lacking in todays trader.

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