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Disclaimer: Since we’re not licensed financial advisors, we aren’t legally allowed to recommend individual assets. We are simply describing the investing strategies that got us here. Please consult a professional before implementing any of these strategies.
So we’ve discussed why Index Investing is the only reliable strategy for investing in the stock market, and we’ve also covered why Modern Portfolio Theory is the best way to control your risk by trading off long term returns for lower volatility (or as I like to call it, “spikiness”).
So how do we put this together?
This is a process called Asset Allocation, or as I like to call it, Slicing the Pie.
Here’s how it works: You start with your portfolio, modelled as the most delicious of all mathematical models, the pie.
Then, you slice that pie into two segments, Bonds and Equities. Remember that the relationship between them is that the more bonds you have, the lower the volatility. The more equities you have, the higher the long term return.
How you decide to do that is based on two things: your Investment Horizon and your Risk Tolerance.
Investment Horizon is simply when you need the money. If you need it in a year to buy a house (PROTIP: DON’T), then you shouldn’t have ANY money in the stock market, because the Index could crash and it may not recover in time for your big purchase. But if you’re investing for retirement, you don’t actually need your money for 15-20 years. In which case, almost all of it should be in equities. This is backed up by hard data, because if you bought the S&P500 at any point in its existence and sat on it for 15 years, you would have a 0% chance of losing money. In fact, you’d have a median return of 12.2%! It makes no sense to buy anything else!
That’s why Larry Swedroe wrote in his excellent book The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments that given an investment timeline, your maximum equity allocation should look like this.
|Your Investment Horizon (years)||Maximum Equity Allocation|
That is based on mathematical truth. If you don’t need the money for 15 years or more, dump it into the Index and let it ride. You stand a 0% chance of losing money. However, by that logic anyone under 40 should be 100% equity, and we intuitively know that’s a bad idea. Why is that?
Because actually being 100% equity is super volatile. We’re talking crashes that took 50% off the index in 2008! And when most people experience that, they freak out and bail. So another way of determining your asset allocation is based on your Loss Tolerance. Which is defined by the maximum short-term downside you’re willing to tolerate before panicking. Larry Swedroe summarizes it thusly.
|Maximum Loss You’ll Tolerate||Maximum Equity Allocation|
Here’s the thing: Larry’s analysis of risk tolerance effectively sums up why investing is so difficult for most people. Rarely is the “correct” answer clear, and most often it’s a tug of war between two opposing forces: Greed and Fear. Logic and Emotion. On paper, everyone under 40 should be 100% equity, but what 20-year-old who’s just starting out in their career can stomach a gut wrenching loss like the one we experienced in 2008?
Investment Horizon is basically set in stone. If you’re 20 or 30, your retirement is decades away, so statistics say you should go all in. But your Loss Tolerance (i.e. the maximum loss you can stomach before jumping off the roof) is the part most people have trouble with. Most people think they’re the stock market equivalent of Clint Eastwood. Until it actually crashes and all your money goes down in flames.
Here’s the truth: Not panicking when markets are plummeting is not easy. It’s similar to an E.R. doc’s ability think on his feet when the his first patient goes into cardiac arrest, or a soldiers’ ability to fight when the first shots start firing. Nobody has any idea how they’ll perform when the pressure’s on.
And some find out they can’t hack it. And that’s fine. No shame in that. But the ones that pull it off usually attribute their survival to two things: their Training and their Experience.
Training. What do I mean by that? Well, no clueless undergrad just walks into their local E.R. and starts dispensing drugs, and no soldier enters a battlefield without going through boot camp. They spend years learning how to do their jobs, and when the shit hits the fan, their training gets them through it.
Fortunately, investing isn’t nearly as difficult as being a doctor, or a soldier. My training involved reading a bunch of books I borrowed from the library, and not buying into the insanity of the housing market. It’s knowledge that anyone can learn, and in fact, that’s the entire point of this blog: To show you that investing really isn’t that hard.
Experience, however, is more difficult to obtain. There’s no real substitute for that first time a trauma surgeon has to resuscitate a dying patient. And no matter how many drills a soldier does, nothing compares them for the first time a rocket gets fired at them. Our skill was forged in 2008. In fact, I remember vividly the moment where everything was on fire, we all thought the world was ending, and my finger was vibrating nervously over the sell button.
But I drew my strength from my faith in the fundamental truth of Index Investing (i.e. it can never go to zero). So I didn’t hit that button. And as a result, we didn’t lose any money in the Great Financial Crisis of 2008.
However, not everyone can do that. And, as a matter of fact, many did sell, and as a result turned paper losses into real losses.
This is where a Financial Advisor really comes in handy. Most people think that the primary job of a Financial Advisor is to pick stocks. To beat the market. But it’s not true. The primary job of a Financial Advisor is to act as a stupidity filter.
Because while we were able to withstand the market crashing, many couldn’t. And they rushed to their eTrade accounts to panic-sell. And those investors got killed.
A Financial Advisor’s primary job isn’t to hit you a home run. A Financial Advisor’s primary job is to stop you from doing anything stupid. Like selling into a storm when everything’s on fire and the Index is dropping by 10% a day.
Here’s the challenge though: Financial Advisors are a dime-a-dozen. But good Financial Advisors are one-in-a-million. And admittedly, that figure is exaggerated for literary purposes, but it’s not exaggerated by much. When we were searching for a Financial Advisor, we interviewed over a dozen people, and almost all of them were just stupid, smarmy salesmen whose advice couldn’t pass a basic Google search.
Whoever you choose to safeguard your money has to be someone who understands and believes in Index Investing. Someone who understands and believes in Early Retirement. And someone who has a proven track record of helping their clients become Millionaires.
I’ll be honest. It’s a tall order. It could take some time.
Next post: “Rebalancing: How to Buy Low Sell High”
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