STOP and Ask Yourself These 4 Questions…Before You Invest
The savvy investor will invest sufficient time and consideration before making any major financial decisions—and part of this consideration should entail a dose of soul-searching and self-reflection with unflinching-bare-all-honesty.
If you haven’t read my previous post on investment options you might want to start there. It’ll be helpful if you’re not already familiar with stocks, bonds, cash equivalents, and other types of investments (not to mention, you don’t want to miss how I compare them to the “groceries” that will fill your “baskets,” or investment accounts).
Today’s post will continue the thread of our larger journey—helping you become financially empowered and literate. It is also part 1 of a 2 part series on asset allocation and developing a portfolio. In this post, part 1, I will discuss my philosophy of investing and four things to consider before developing a portfolio. In part 2, I will talk about portfolio development in more detail. Crawl, then walk, then run.
You want to pause and pay special attention right now, because I’m about to drop some heavy truth on you, but it’s also going to be kinda zen, in a way. Ready?
Your most important portfolio decision can be summed up in just two words: asset allocation. A portfolio is a collection of investments. The number of and percentage of each investment type within a portfolio is referred to as asset allocation.
Own the risk
Before you even think about choosing investments, understand that investing is always associated with some degree of risk. There’s no getting out of investing (unless you want to put your money under your mattress) and there’s no investment that is completely risk free. The closest you can come to investing risk free is with certificates of deposit, which pay a guaranteed interest rate, or treasuries, that are backed by the U.S. government (however, many would argue that investing in these types of lower yield options is itself a risk because they don’t do more than keep up with inflation and sometimes they don’t even do that). If saving for retirement is your goal, you will have a hard time getting there by investing solely in cash equivalents and bonds.
“What goes up must come down.”
The second important concept I want to emphasize loudly and often is that markets go up and down. Anticipate this. If and when you decide to invest your money, particularly into the stock market, expect that over the long term you are going to see several large swings. Everybody loves it when the market goes up. But most people are uncomfortable at seeing their accounts go down in value, particularly at drops of 50% or more. Remember that this kind of volatility is to be expected. It is normal. You will not panic when the market drops by a large amount if you are expecting it to happen. Accepting this volatility is part of the pact you make with yourself when you decide to invest.
Why is this important to understand? Because if you develop a financial plan that will take you through retirement, and you understand that the market will go up and down during that time, you won’t change your plan based on market volatility—and consequently, you can avoid sending your happy cushy retirement plans down the drain because you got spooked and deviated from the plan. When you make a plan, you factor in the short-term fluctuations that occur.
Although a complete discussion of a financial plan is the subject of a separate post, it’s necessary to touch on it in order to choose an asset allocation right for you. There are four main considerations in doing so:
1. What are your goals?
Most radiologists have several financial goals: vacation, house down payment, new car, kids’ college education, and retirement, to name a few. Each individual’s goals are personal. The amount of money you need to save to buy a house depends on what kind of house you want. What you need for retirement depends on when you want to retire and what kind of lifestyle you want in retirement. Saving for children’s college tuition will depend on how many children you have, how much you want to contribute, and what kind of colleges are under consideration (e.g., more affordable local public colleges versus more expensive private colleges).
2. What is your time frame?
Some of your goals will be more immediate (accumulating an emergency fund, paying for a wedding in one year, saving for this year’s vacation), some a long way down the road (retirement), and many in-between (saving for a house down payment, new car, and kid’s college education). How you invest your money will depend on when the money is needed. Since stocks are the most volatile and risky of the three major types of investments, they are an unsuitable choice if you will need to spend the money in less than 5 years (some would argue as long as 10 years).
Now for some perspective, consider the following tables:
The table below, showing the worst and best returns of large domestic stocks from 1935-2013, illustrates how the range is less extreme over ten years compared with 1 or 5.
Annualized Returns of Large Domestic Stocks 1935-2013
|Time Period||Worst Return||Best Return|
From Lindauer M, Larimore T, LeBoeuf M. The Bogleheads’ Guide to Investing, 2nd Ed. Hoboken, NJ: John Wiley & Sons, Inc., New Jersey; 2014
The following historical look on stock returns from 1926-2018 duplicates the above findings but also shows that stocks are more commonly up than down in any given year:
|Average annual return||10.1%|
|Best year (1933)||54.2%|
|Worst year (1931)||-43.1%|
|Years with a loss||26 of 93|
The historical risk/return on bonds from 1926-2018 is much less volatile:
|Average annual return||5.3%|
|Best year (1982)||32.6%|
|Worst year (1969)||-8.1%|
|Years with a loss||14 of 93|
3. What is your risk tolerance?
How much to invest in cash equivalents, bonds, stocks, or other investments will depend in part on the mix that will “let you sleep at night” and not cause you to panic and sell out when the markets crash. Until you have owned stocks/stock funds in a severe bear market (i.e., market decline), it’s very difficult to know how far your investments would need to decline before you would decide to sell. If you think you would stay the course no matter what, you might be fooling yourself.
In 2002, when the NASDAQ Composite Index (one of the three most-followed indices in US stock markets, along with the Dow Jones Industrial Average and the S&P 500) dropped from an all-time high of 5,049 to 1,224, investors who sold at that time realized a 75% loss. Why would they do that, you wonder? It’s not such a mystery if you put yourself in their shoes. They watched their hard-earned savings steadily erode, they got discouraged by the constant “doom and gloom” portrayed in the media and from conversations with friends and family, the “experts” on television proclaimed that the market would continue to go down, newspaper and magazine articles confirmed the worst was yet to come, and maybe their family lost faith in their investing plan, urging to “sell before it’s too late.”
If you would sell out of fear when the market is down, you should probably not be heavily invested in stocks (certainly not 100%) and should be holding more bonds. However, if you can honestly say, “No, I wouldn’t sell because I know that U.S. bear markets have always come back higher than before,” you can probably take greater risk. If you’ve never experienced a bear market, you don’t know how you will react, and should probably be holding at least 10-20% bonds. In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
4. What is your personal financial situation?
If you have a pension and social security income, you don’t need as big of a retirement portfolio as someone without these resources. If you have a significant net worth, you do not need to invest in risky investments in search of higher returns. Once you’ve won the game, you can stop playing.
Now that I’ve laid out several things to think about before getting to the business of choosing investments, and you’re forearmed and forewarned about the risks of investing and understand your own personal foibles, you are ready to develop your personal portfolio. Be sure to read my next post where I will tell you how to do that.