So you’ve sorted out your personal finances and would like to start investing. You have enough cash to cover your day-to-day living expenses. You have savings for things like vacations, college, weddings, etc. You’re contributing enough to your pension to max out the employer match and tax deductions. You’ve paid the premiums for the insurance policies you really need. And after all that, you have money left that you probably won’t need for the next five years and you want to invest it. Where to start?
As to when to start, the answer is as soon as you can. It doesn’t have to be a lot and it can be as simple as buying a low-cost index fund or ETF. Time in the market is more important than timing the market. No one knows which way the market will go in the short-term and if you’re unlucky and the market drops shortly after you invest, it’s okay – you don’t need the money for the next five years right? Getting started can often be a hurdle for many people, so make it simple. Commit to investing the same amount each month whether the market is up or down. This way, you will benefit from dollar-cost averaging, in that you will buy fewer units when prices are high and more when prices are low. Over time, the average price you pay is somewhere between the market low and the market high.
Buying an index fund or ETF also gives you instant diversification. Diversification simply means spreading your portfolio across different investments to reduce the effect of any single investment dropping significantly in value. Diversification also necessarily means reducing your potential gains. In effect, it narrows the range within which your portfolio will perform. It lowers the likelihood of a large loss but also lowers the likelihood of a large gain. The former is preferable as you get closer to retirement, but the latter can be a hindrance to building wealth when you are younger. There are a couple of ways to diversify your portfolio.
However, as your investment portfolio grows, you will need a better plan. Plans change but how you construct your portfolio depends on two main factors – your age and your tolerance to risk.
Stocks vs Bonds
One way to diversify your portfolio is to invest in different asset classes. There are many asset classes – cash, stocks, bonds, property, art, etc. – each with its own risk/reward characteristics. For simplicity, we’ll stick with stocks and bonds as they are the most liquid and the ones most ordinary investors encounter. Bonds offer higher stability than stocks but have lower returns.
A common approach to managing risk is to split your investment portfolio between stocks and bonds. A traditional allocation is to aim for a 60:40 split between stocks and bonds; there are even funds that mirror this allocation, such as the Vanguard Balanced Index Fund. However, this allocation does not account for changing financial requirements as you age. Another method is to have the percentage invested in stocks to be 100 minus your age. So, if you are 20 years old, you would have 80% in equities and 20% in bonds, and when you are 60, you would have 40% in equities and 60% in bonds. The general idea is that as you get older, you have less time for the stock market to recover from downturns, and would want more of your money in more stable assets. You gradually shift from wealth accumulation towards wealth preservation.
Personally, I think that for someone who has just started working in their early 20s, an allocation of 20% in bonds is too conservative. Time is on their side. They have over 40 years to ride out the ups and downs of the stock market. Having no bonds for someone in their 20s might be more suitable for some people. So perhaps an equity allocation of 120 minus your age is more suitable for you. Or you may forgo the bond component altogether and diversify your portfolio differently. It all depends on your appetite for risk.
At Telescope Investing, our focus is on building wealth by investing in the stock market. We do not subscribe to having a large portion of your portfolio invested in bonds, if at all. The returns from bonds are simply too low to make significant gains and can destroy long-term returns if utilised too early.
| Age | 20 | 30 | 40 | 50 | 60 | 70 |
|---|---|---|---|---|---|---|
| Stocks | 100% | 90% | 80% | 70% | 60% | 50% |
| Bonds | 0% | 10% | 20% | 30% | 40% | 50% |
With any allocation scheme, the risk mitigation benefits come from rebalancing, where you move funds from the overperforming parts of your portfolio to the underperforming parts, and return your portfolio to the desired percentage split. Some years stocks perform better, and in others, bonds perform better. Here, you are selling assets when they are high and buying assets when they are low. This benefit of rebalancing doesn’t apply to individual stocks. Winners tend to keep winning for individual stocks, but you may still want to rebalance individual stocks for the same reason, to reduce risk.
If you have no interest in researching companies and choosing individual stocks, investing in low-cost index funds and ETFs is perfectly acceptable. We do not recommend investing in actively managed funds which often come with high management fees. These fees apply year in, year out whether the fund loses or gains, and over decades can decimate your investment gains. If you prefer a more hands-off approach to portfolio management, Robo-advisors such as Wealthfront or Nutmeg can help to automate much of the portfolio allocation between funds with different risk/reward profiles and give you an overall portfolio suitable for your investment goals. They can also automate the rebalancing and help with tax efficiency.
But you’re here because you want to invest in individual stocks. Investing in index funds and individual stocks are not mutually exclusive. You could (and probably should) have the bond portion of your portfolio in a bond fund, as it is not convenient for most investors to buy individual bonds. And the equities part of the portfolio can be in individual stocks, or a combination of funds/ETFs and individual stocks. It is often easier to start investing in index funds as they provide instant diversification and can serve as a foundation on which to add individual stocks.
Where in the world…
The U.S. stock market has outperformed most major stock markets over the last 10 years, but this may not always be the case. Markets tend to be cyclical, in that different parts of the world will perform better at different times. If you’re investing in funds, you may want to split your portfolio between a North American index fund, a European index fund and an Asia-Pacific index fund, for example. Again the risk mitigation benefits come from periodic rebalancing.
For individual stocks, you may want to split your portfolio between your home market and a major market, which typically means the U.S. stock market. Investing in your home market is advantageous for a couple of reasons. You will be more familiar with the companies in your home market and the stocks will be in your home currency and won’t be subject to currency rate fluctuations. And investing in a major market is useful because it will have high liquidity (easier to buy and sell with narrower spreads) and is home to some of the most well-known global companies in the world, as well some of the fastest-growing smaller companies because they are operating in a large economy. It is also easier to find news and information for a large open market such as the U.S.
What business are you in?
Different industries can also be cyclical, and different businesses will do better at different times. Sometimes, a whole sector may go up or down due to factors largely outside of the companies’ control.
You don’t have to worry too much about this if you are investing in a broad market index fund such as an S&P 500 tracker or FTSE 100 tracker (not so much with the Hang Seng Index, which only has 50 stocks and is dominated by banking and property.) The index fund will include companies from several industries. If you’re investing in sector funds, then you may want to avoid putting all your eggs in one basket. Similarly, for individual stocks, you will probably want to spread your investment across a number of sectors.
You can have too much diversification. If you have close to say, 100 stocks, your overall portfolio performance will likely be close to the index. You might as well invest in the index and save yourself the trouble of having to keep track of 100 different stocks. The aim of investing in individual stocks is to beat the index, and we believe the way to do that is to have a relatively concentrated portfolio of fast-growing companies operating in markets that have inherent tailwinds. A reasonable target would be to aim for 20 stocks across 5 different sectors.
Embrace the volatility
Some stocks move up and down more than others. They may gain more when markets are rising but may drop more when markets are falling. This is referred to as volatility. The companies comprising broad market indices such as the S&P 500 are usually the larger companies which tend to have low to medium volatility. However, you can also opt for a small companies index fund or ETF, which will have higher volatility.
The principle of having more stable assets as you age applies here as well. You do not want your portfolio to drop significantly just before and during retirement and turn a comfortable retirement into a chore. As well as using the broader allocation between stocks and bonds, you can also use a similar method within the stock component of the portfolio by increasing the proportion of lower volatility stocks and decreasing that of higher volatility stocks as you get older. In this way, you can limit the downside of market crashes while still benefiting when the market rises.
| Age | 20 | 30 | 40 | 50 | 60 | 70 |
|---|---|---|---|---|---|---|
| Cash | 10% | 10% | 10% | 10% | 10% | 10% |
| Low | 10% | 15% | 20% | 30% | 40% | 50% |
| Medium | 20% | 25% | 30% | 30% | 30% | 30% |
| High | 60% | 50% | 40% | 30% | 20% | 10% |
I should stress again that this is just an example, not a recommendation. Any allocation scheme must suit your financial situation, financial goals, appetite for risk and investment style.
Why not have everything in high volatility stocks until retirement to maximise my gains and then switch to lower volatility stocks then? You can certainly do that but there are good reasons why you shouldn’t. One, because market crashes can happen at any time and often happen very suddenly and quickly (as if you need reminding in 2020). Life is unpredictable and you may suddenly find yourself needing to sell investments to cover an unexpected expense. You may decide to retire early and travel the world. It’s also easier to sleep at night when you’re not worrying that your portfolio could suddenly halve in value.
If you’re investing in individual stocks, you may ask, “But how do I know which are low, medium and high volatility stocks”. If you spend enough time looking at stocks, you will get an intuitive feel of whether a stock has low or high volatility. There is also a stock measure called beta which indicates how much a stock price will move relative to the overall market. This number is available from some finance sites. There is no official definition of low, medium and high volatility but a beta of less than one is often regarded as low volatility. As for medium and high volatility, I regard a beta between 1.0 and 1.5 as medium and anything above 1.5 as high.
Having a cash position within a stock portfolio may sound strange, but it can be useful to have to take advantage of market crashes and buy stocks when prices are low. We will cover this in more detail in another post.
Conclusion
These are more guidelines than hard and fast rules. Any investment strategy must be tailored to the individual. Financial situation, financial goals and risk appetite all play a role in determining your investment strategy. The important points are that you invest if you are financially able to and to have a plan.
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