Wise Investing: Snoozing Without Losing

Making your money work for you sounds great, but when it comes down to the details of it, things start to get a bit hazy. Investing is one of the few things that people should start thinking about at a really young age. Investing is a lifestyle skill rather than a financial skill. Unfortunately, these skills aren’t taught in school.

With people losing huge amounts of money, through financial professionals who abuse their positions, investment has become a scary idea. For instance, many are convinced of guaranteed investment by financial companies, but the reality is that if the company goes bankrupt, then your money disappears with them too. Honestly, I have very negative feelings when I hear of financial professionals using their professionalism and skill to abuse retail investors, who are the majority of the population and often don’t know the ins and outs of the financial markets.

“Saving is a lifelong activity, and investing is an integral part of it.”

Yet, at the same time, everyone knows that just keeping your money in the bank often depreciates its value by giving you a negative return when adjusted for inflation, so people are still keen on investing. So, I’m passionate about equipping every individual with the right tools and knowledge to invest better.

So how do you even begin to make smart investments? You need to know your investment profile – your risk appetite, return needs and how to start saving your funds to invest.

Assess Your Risk Appetite

Before you can start investing, you need to plan your investments around your risk appetite. Risk appetite is an important psychological factor that many tend to overlook. A lot of people often tend to over-exaggerate the risk that they are ready to accept while concurrently overestimating the potential returns of investments. This ultimately means that those individuals are making riskier decisions with lower returns which can potentially lead to a situation they can’t psychologically deal with. So first, you need to assess your true risk appetite.

Ask yourself what kind of drawdowns you are comfortable with. For instance, if your portfolio drops by 10% or 20% tomorrow, are you okay with that? If you are then it means you have a high risk appetite, if not then you need to know what is a number you are comfortable with so that you know which types of investments to look into.

Investment risk is generally defined as the degree of potential financial loss inherent in an investment decision. Ask yourself what kind of loss are you willing to have on your portfolio? Can you stomach the loss and not be depressed about it? After the loss, do you have the energy to stand back up and continue investing again? Would you prefer the additional peace of mind that comes with steadily growing your money with a percentage that’s just slightly higher than what the banks offer you? Or would you lose interest with such a slow-paced investment approach?

As a rule of thumb, if an investor can accept above 30% drawdown on a portfolio within a year, I consider him or her to have a very high risk appetite, 20-30% would be a high risk, 10-20% a moderate risk and anything below 10% as a conservative to moderate.

As you assess your risk appetite, you also need to know what your purpose for investing is. Psychology is an integral part of investing, and if you don't know your reason for investing, your investment portfolio can’t be structured to suit your goals. What exactly are you saving for and why?

Also, it is useful to reflect on your investment biases. Do you have any particular investment thematic that appeals to you? For example, you might favour biotechnology because you personally want to see such businesses take off. Is your bias empowering or limiting for you?

Start assessing yourself realistically and note down your thresholds.

Evaluate Your Return Needs

After you’ve assessed your risk appetite, you need to know what kind of realistic returns you’re looking for and how fast you expect them.

Your return objective has to be compatible with the risk level of the investment portfolio. For example, if you’re looking for around a 30% to 40% return within a year because you want to grow your finances fast, then you often must accept a proportional risk profile for your investments (which is very high risk). With a lower risk investment, you are likely to miss your goals and lose patience. To get high returns quickly, you would instead need to look at riskier investments like derivatives and FOREX, but those can result in a loss of 100% of your invested capital. So, if your risk appetite is high enough and you can stomach such losses, then that’s fine, but if not then you might have to deal with the unintended consequences. The goal of achieving high returns with a low risk portfolio, while ideal, is difficult to achieve. Investors are usually compensated with higher potential returns for additional risks that they are willing to undertake. You have to ask yourself if there might there be a mismatch between your expected returns and your risk profile.

“Your timeframe changes everything.”

If your timeframe is short, then you have to understand that there is less flexibility. Within a short timeframe of let’s say a year or a few months, you might be caught in a downswing. If you need to cash out fast, then you have to accept that you may not cash out at a good price. Especially if you are interested in investing in volatile instruments like tech stocks, there’s a high chance you may get caught in a downswing if you have a short timeframe. The shorter your time horizon, the more vulnerable you are to market fluctuations in your portfolio.

If you have a longer time frame, then you have more flexibility. You will be able to make more informed decisions or employ better timing when exiting your investments. There is kind of a rule of thumb which is to look at your investments in the horizon of at least three to five years. Depending on the style of your investments, you may even need up to 10 years to get liquidity on your investment (for e.g. in case of Private Equity and Venture Capital).

So again, you need to know what your timeframes are, and I would suggest that you have longer timeframes so that you can have more flexibility and be in a position to cash out favourably. Moreover, longer time frames will often enable you to find investments with positive asymmetric risk or return. This means that you can get more dollars of return per unit of risk you take.

Regardless of whether you have a short or long timeframe in mind, I would advise everyone to leverage on compounding.

Don’t Underestimate Compounding

Compounding is a powerful long-term tool that you should be considering especially when you are young. For example, if you look at the S&P 500 index, you would find that it has grown significantly since the beginning of the new millennium (January 2000 till December 2018) – by more than 70%. However, if you calculate the index’s compounded annual growth rate, the percentage would be slightly above 3%. A percentage return that may look small can help you build up a significant savings account, especially if you are a young person and have many years ahead of you.

It’s a common adage that younger people should take more risks, but my advice is that just because you could, doesn't mean you should. If you're young and have 50 years ahead of you, you can leverage on compounding to generate a significant amount of savings within 50 years, just from the sheer power of compounding. For instance, if you made 5% per year (after tax) on your portfolio for the next 50 years it will grow by 11 times in that period. In the same manner, if you save USD 1,000 per year and invest it at 5% you will have around USD 220,000 by the end of year 50.

While your youth is the time to take risks and explore a wide range of possibilities in life, it is important to remember that losses resulting from riskier investments will prevent you from leveraging on the power of compounding.

I am not saying being young or old is better for investing. Different opportunities open up at different stages in life. The stage in life of a person, however, should be an important factor to consider in your risk profile. In any case, compounding is your ally at any age. Make good use of it.

Start a Saving Tactic

Finally, if you don’t already have one, then you need to start a saving tactic. There are different ways of saving, but something that works effectively is what I read from a book called The Richest Man in Babylon. Simply put, the book writes that you should set aside a certain percentage of income into your investment portfolio, regardless of your spending plans.

Many people invest what they have left after spending, but it is more effective to spend what is left after investing. It is an obvious statement, but the more savings you generate, the greater your base for generating return and the stronger the flexibility of your lifestyle in the future. Of course, how much we can save varies across individuals, but 20% is a good gauge to build a base for your investment portfolio. Again, the more you save, the more you benefit from compounding.

Of course, there needs to be a certain structure that makes your savings plan realistic because you can’t just keep on saving for some mystical future and give up the chances to travel and see the World, contribute to society, buy things for yourself, or get presents for others. We all have certain things that we desire while saving and we shouldn't be forgetting about such things. Like with many other things in life, it is important to find the right balance between saving, giving and spending that fits you and only you know where this elusive balance lies.

In most situations, especially where you are saving out of your salary, having a strong aversion to losing money is a good practice. When you are gradually building up your portfolio, any loss would have a compounding effect on your future. So, it's better to have a safer risk profile and enjoy longer years of compounding, rather than exposing yourself to volatile investments. It doesn't mean your portfolio shouldn't have drawdowns, just don’t invest in things you don’t understand.

Which investment tool is the right tool? I have met many people who have the impression that trading on the Foreign Exchange (FOREX) can earn you a lot of quick money. It seems that way because a lot of brokers are often offering a 100 to 1 leverage and you can have a fairly limited monetary capital and still theoretically enjoy high returns. Yet it’s actually one of the most challenging markets to invest in because it’s difficult to understand and involves many factors.

To make an informed decision, you need to understand the relevant market fundamentals, including dynamics between the two countries, their trade balances, and state of political affairs between them. You need to be able to predict what kind of decisions will be made that will affect the currency. There are so many factors just to understand a single currency pair, and it's very naive to think that you can simply sit down in front of a trading terminal and predict how the foreign exchange markets will behave.

If you want to start with a more stable and predictable market, it should be the fixed income or equities market because these are markets that you can gain a fair understanding of through self-education and logic.

You need to use the right tools to generate the returns you expect, and you need to have the right amount of funds to use the various tools. Ultimately, the tools you use will depend on your return need, risk appetite and how much you have to invest. If your return objective is high, say in the double digits, then you have to use the right tools and be realistic about the potential outcomes.

The natural question is – what is a good return? Is it 20% or 2%? Now, this needs to be looked at in the framework of what we call risk-adjusted return. Essentially this means that your returns are adjusted based on the kind of risk you’re taking, and this varies across asset classes.

I’m going to lay out these various asset classes and what kind of capital and risks they involve so that you can make an informed decision.

Fixed Income or Bonds

If your return objective is 5 to 7%, then you can realistically get that with fixed income. Generally, retail investors should aim for a portfolio comprising of equities and fixed income. You can be investing in fixed income with 10K or 100K and still be able to generate a stable return of 5 to 7%. For anything less than a million in liquid net worth, it's best to stay on this side of traditional instruments like fixed income and equities.

As a bonds investor if your portfolio consists of bonds issued by large companies with a decent credit rating (measure of stability) which are well transacted (have adequate liquidity), then a 7% return would be considered a good return. A great return would be 9%, a decent return would be 5%, and a bad return would be below 2%. If it falls to minus 10%-20%, then something terrible must be happening in the market because investing in good quality bonds is considered to be quite conservative.

If you are investing in bonds with less than a $1 million then you should look for US-listed bonds because they offer smaller minimum sizes (often as small as USD 2,000). If you allocate $25,000 per bond, for example, that's a size you can sell back later. You can then have a diversified portfolio of 20 bonds. You can also buy bite-sized pieces, as small as $2000. The downside of that is it's unlikely that you will be able to sell them because of the small size. Not many people are willing to buy at those volumes, so you need to consider that. If you're looking to hold to maturity, then that's fine. If you have more than $2 million, then you would want to consider approaching an investment bank which can offer you access to better pricing.

Equities

If your investment objective is about 7 to 15%, then you have to dive into equities, but you need to be able to accept a bigger drawdown. Equities are a very broad market and performance should be considered relative to a benchmark, but in general, a good return would be 10 to 15%, a great return would be 15 to 20%, a decent return would be 7% to 10%, and a bad return would be below 5%.

Some of the greatest equity fund managers, like Bridgewater Associates or Renaissance Technologies, are famed for being able to consistently “beat the market” and make a return of over 20% on some of their strategies, which is considered great. If you can replicate that and deliver such returns over a period of 5 years, hats off to you. As for most investors, according to various research, over 90% of actively managed funds fail to “beat the market”. So, unless you have a very specific skill or an explicit reason to be investing in a certain company, I would urge you to diversify your equity portfolio as much as you can. Better yet, go for a broad market Exchange Traded Fund (ETF) and I have a whole book on that for you to read.

Private Equity (PE) / Venture Capital (VC)

If your return objective is even higher than 15%, then you can look at private markets, but you must be able to stomach potential full loss of invested capital. It's less predictable and less liquid, and therefore I recommend to have controlled exposure to private markets and look at them as a part of your larger portfolio.

Potential return on equity or shares of private (unlisted) companies depends on the stage of the company. Businesses in the later stage should be giving you above 20% per annum for it to be considered a good return (often referred to as PE investing). If it is a very early stage business (for example, an IT start-up), you should make about 30% for it to be regarded as a good amount of return (often referred to as VC investing). But if you are to invest in this, you have to have a clear understanding of the risk. For instance, IT start-ups are a great investment tool, but on average 9 out of 10 start-ups fail.

For any investment, diversification is key, but it is doubly true when investing in private markets. Again, this is an oversimplification, but to have a reasonably diversified PE/VC you would typically need at least a million dollars specially allocated for this (preferably spread across at least 10 companies). If you don't have specific expertise in investing into businesses or your capital base is not sufficient to have a diversified PE/VC portfolio, then you can go for PE/VC fund or an Exchange Traded Fund (ETF) that will give you diversified exposure to private markets.