Whenever you request guidance on how to invest to reach FIRE, you will often receive the comment you should invest in Emerging Markets e.g. through IWDA + EMIM. But should you?
Last Updated on May 22, 2020 by Mr. FightToFIRE
At the beginning of every year, I get a letter from the bank I have an investment portfolio with to review my investment and based on a questionnaire reevaluate what type of investor I am, i.e., my investment profile. Then based on the result we check what’s the most optimal way to invest my money.
While this sounds annoying, know that Europe mandates this to all European banks as part of the MiFID or Markets in Financial Instruments Directive.
Now, I’m not saying you should head to your bank and invest with them, but the questions they ask do provide a solid basis to help you take your first steps in investing. It helps determine your asset allocation or at least the one that will most likely fit you best for your risk appetite.
If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring"
Hungarian-American investor and philanthropist
By getting clarity on what kind of investor you are, emotions are left at the door.
Here’s already a hint: If you can’t sleep at night because you have an important meeting the next day, you are more risk-averse than you think.
Determining your optimal investment type
Before you go off and make your first purchases in the stock market, you should first know what kind of investor you are. To determine this, you must ask yourself how much risk you can handle and how long you are willing, and can, wait to recover from a (possible paper) loss in the event of a bear market (>20% decline of a given stock/index).
The mix that fits your needs is largely determined by two main factors:
- Investment horizon
- Risk tolerance
Or in other words, how long you can hold your investment without the need to sell. Investors with a longer investment horizon can take on more risk. In the event of a bear market, the long-term investor has time on his side and can sweat out a bearish market.
An investor with a longer investment horizon, typically 20 – 30 years, will have most of their assets allocated to equities. Stocks have much higher volatility over short time periods than bonds, but this evens out over time and over 30 years, you will have gotten close to the market average of 8% (excl. inflation). Investors with nearing their retirement will have a much shorter investment horizon, less than 10 years, and can’t wait out a decline in the stock market as they would be required to sell their stocks upon retirement and risk selling at a loss.
The more often an investor counts his money — or looks at the value of his mutual funds in the newspaper — the lower his risk tolerance."
American economist and Nobel Memorial Prize winner in Economic Sciences
Every type of investment has some level of risk, i.e., some amount of uncertainty with the possibility of financial loss that one can handle. Risk tolerance is how much volatility you are willing to handle with your investments. If you take on more risk than you’re comfortable with, you may succumb to emotion-based trading leading to selling low and buying high.
Three main influences
These two main factors are for a large part dictated by:
- Your financial situation, this will influence how much you are willing to risk and thus impacts your risk tolerance. A millionaire will have the luxury of playing it safe or risk it all with a limit amount of capital. Someone who has a low income and just enough savings to last 2 months of unemployment might not risk anything and will either have to wait and save more or put it all in short-term government bonds.
- The knowledge and experience you have about the financial products you wish to invest in. Someone who has read a lot about the financial markets might be more comfortable in investing in stocks or more risky equities. This can, however, also mean he might think he can take a higher risk but when a bear market happens, he might be the first to sell. A person with limited knowledge will play it safe and assume the worst can happen and knows he won’t feel comfortable having a majority of his wealth invested in stocks.
- Any investment goals you might have. This will also determine your investment horizon. if you are investing to reach FIRE and start early in life, you can have an investment horizon of 20 years. If your goal is to buy a house, chances are you can only miss your money for 5 years.
You might think this explanation is still abstract. Enter the aforementioned questionnaire. To make this more concrete and to actually get a risk profile without having to go to a bank I give you two investment risk assessments:
what type of investor are you? The choice is yours
With the risk assessment done, either through a questionnaire or by self-reflection, it’s time to choose and determine which profile and corresponding asset allocation works best for you. The next table contains 6 main profile types to choose from.
Note that at the end of the day, this is still just a guideline. You are free to ignore all of this and go full in stocks even though you’ll be having nightmares every day of the week or you actually need the money in a year or two – three. It’s your choice.
|Nr.||Portfolio distribution||Max. loss tolerance||Character||Investor type|
|1||100% bonds||0%||Very defensive||For those investors that are completely risk averse and for those that consider return as secondary importance.|
|2||80% bonds / 20% stocks||10%||Defensive||This is for the investor that prefers calm over return.|
|3||60% bonds / 40% stocks||20%||Moderate defensive||If you wish to get a bit more return and don't mind some volatility.|
|4||40% bonds / 60% stocks||30%||Moderate aggressive||When you are looking for growth over the long-term but still like to keep risk in check.|
|5||20% bonds / 80% stocks||40%||Aggressive||For the investor that are looking for good returns and can accept larger volatility in their portfolio.|
|6||100% stocks||50%||Very aggressive||Only for those that can accept very volatile markets, and can take a hit that takes multiple years to recover from.|
When you have an idea about your risk tolerance and what your portfolio mix is, you can finally start looking into a broker that will keep the costs of your purchases low. I recommend you have a look at my preferred brokers to determine which one fits you.
Rinse and repeat
Knowing what type of investor you are is but the first step. As you start investing and create your portfolio it’s important to realize you need to re-evaluate your allocation ever so often. By doing this evaluation, you can accommodate changes in any of the previously mentioned influences (financial situation, your knowledge, and investment goal). I’ve found out that it can be interesting to hold two different periodic revisions:
- Once per year, you make sure that your original mix is still valid. Over the course of a year, stocks can rise and bonds can drop or vice versa.
If your original mix is 60% stocks and 40% bonds, it’s possible that a year later this has changed to 67% stocks and 33% bonds. This might seem minor but if your investment horizon is relatively short, you don’t want to risk a bigger loss than you are comfortable with. As long as the difference is less than 5% you can most likely ignore the difference, but this is personal.
- Every 5 years, a revision of your preferred mix will help you minimize the risk of facing major draw down as you inch closer to your investment deadline.
Do you have a clear view on your investment horizon and risk tolerance? Share it in the comments below.