This 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 have grown a sizable financial nut and absolutely hate losing money.
* Who want a potentially higher rate of growth on their net worth.
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 Motif Investing, where I buy a basket of 30 stocks at a time for only $9.95 (a motif) to invest in ideas. Motif Investing is a cheap and efficient way to gain exposure to ideas. There are over 150 professional built motifs to purchase, or over 70,000 motifs created by the motif investing social community. Motif is way more fun and cheaper than going through a brokerage firm like E&TRADE.
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. The tool is absolutely free and also helps track your net worth and manage your cash flow / budget. Make sure to link up all your accounts so you can get a holistic view of all your finances.
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.
INVESTMENT PLATFORM RECOMMENDATION
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About the Author: Sam began investing his own money ever since he opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2016 and beyond.