How to Invest Part 2
The first How to Invest article addressed deciding how much money you want to invest in traditional investments, such as stocks and bonds. The next step toward smart investing is choosing how much risk you want to have with your investment money, which I’l cover in this article. Be sure to watch, also, this video in this how to invest series where I show you how to check the performance of any major type of investment, as explained below.
You’ll want to have a seperate account, or “bucket”, with a designated nine to twelve months worth of living expenses in a very low risk investment that has little or no change in value. This is not investment money that I’m referring to here; this is reserve money in case you lose your job, or have some sort of emergency. It’s your “sleep well at night savings without risk”…
But what’s your “sleep well at night risk level” for the money that you’re chosing to invest?
“Choosing” may seem like an funny word to use for deciding on your risk level, since the choice we all really want to make is zero risk; but zero risk almost always means zero return, and that’s not putting your money to work for you.
The great thing about using the word “choose’ is that it puts you in control of your money just by realizing that what you do with your money is a choice. Control breeds confidence and harmony. These are the mindset qualities of wealth, not avoidance and dependence.
Choice also breeds empowerment. While responsibility for your money can feel big and even scary, it’s your money. And these are your choices, regardless of whether you self invest or hire a financial advisor. (In reality, it’s all self investing, since you choose (or avoid or delegate the choice) of which financial advisor to use.)
So, what percent risk number do you choose?
Could you live with losing 10%, 25%, or even 40% of the value of your overall investments?
What’s the magic level that will allow you to take enough risk to grow your money while also sleeping well at night? Only you can make that determination….
Play with your numbers. Use real numbers, not just percentages. For example, if you’re considering investing $100,000 in a stock fund, and your chosen risk level is 20%, this means that the value of your investment could decline by $20,000, and you’d be okay.
Remember, too, that a decline in value is not necessarily losing $20,000. That $20,000 loss occurs only when you choose to sell once the investment has declined by 20%. (This is called a “realized loss” in investing lingo. It’s realized alright, in both your investment account and your gut!)
If you don’t sell, you have an “unrealized loss” in investing lingo. At this point, the investment may go down more, or it may rebound within only a few months, as the October 1987 stock market correction did; it was a quick but dramatic drop that bounced right back over the next few months. Or it may slowly (and painstakingly) climb back up over a few years…Or your investment may never go back up, but investing in a well diversified fund, such as an index fund makes this extremely unlikely. (If the stock market in the U.S. goes under, we’ve all got bigger problems than investment losses:)….
But what I’m focusing on in this article is just choosing the amount of decline in value that you can comfortably live with, whether you later choose to sell or hold the investment once it’s declined.
As you can envision, this decline risk level is very much related to your age, your dependents, your wealth level, and your income level…And by making a decision ahead about how much of a decline you accept, you lose being a “victim” to the markets. You feel slightly more in control because you owned that probability of decline when you made the investment. (Ideally, the investment increased in value before the decline, which is why it’s smart to “check the price” of any investment before you make it.)
Now, there’s some fancy software financial advisors use that calculates the ideal investments for you based on all of these factors, and it’s valuable, but sometimes fancy software clouds the simple reality of this important principle. Investments go up and down.
So, know your numbers; know how much you’re willing to risk in your investment accounts. Test the thought process with your money…and your chosen risk level.
Are you now wondering how much risk a particular type of investment has?
Since you can find out how much almost any traditional investment you’re considering has declined in value in the past, you can use this number as an estimate for potential future risk. History tends to repeat itself to some extent.
We all know the teeny tiny lettering or the speedy voice at the end of financial commercials that tell us that past performance is no guarantee of future performance, and hence, past risk is no guarantee of future risk, but that’s mostly to avoid a lawsuit and stay in compliance with the many regulations that are now in place for financial companies (which, unfortunately lead us to believe that someone else is responsible for our money, but that’s another post entirely).
Let’s be real here…you have to start with something to estimate risk before handing over your money. The reality is that IF you are going to invest in anything other than cash or near cash equivalents, you will have ups and downs in your investment accounts. And the best place to look for those estimates is past performance. (Isn’t this true with pretty much everything in life if you think about it?)
So, if you’re going to invest in a stock fund, just check to see how much it has declined in value in the past. If you’re going to invest in a bond fund, look to see how much that same type of bond fund has declined in the past. These numbers are easy to find; they are published, and an index fund decline gives you the percent of past declines for diversified stock funds….(more below)
The next question is “when did the fund (or managed account or money manager) have a large decline“?
Have large declines happened often?
How long ago was that last large decline?
While it may seem comforting if a decline occurred in the distant past rather than near past, in reality, a recent large decline would indicate that you’re more likely to be buying near the bottom of an investment cycle than near the top, thereby reducing your risk, and buying near the bottom is a great investment principle.
Next, see how many years the fund has been around. Here’s a trick: Some funds get renamed after bad performance, and get a fresh start that doesn’t reveal large declines by getting a new name. (Opps! We messed up and lost a lot of money, so let’s rename that fund and start with new performance results. It happens, and now you know.)
Here’s a great tool…
Since most large stock or bond funds mimic the related index, you can also just look to see how much value the index has lost in the past as a reliable guide.
It may seem as though starting with risk focuses only on the downside, but if you know how much the value of your investments may realistically decline, and then you can be at peace with your investments.
Being at peace with your money allows you to live happily. And what good is money if you’re not happy?
In summary, (at last:), take the percentage amount of the past declines, and see if it falls within the amount of risk you’re willing to accept with your money. Do this for all the types of investments that you have. This may sound like a lot of work, but you probably have only two to four main categories, such as stocks, bonds and real estate. (In general, these different kinds of investments tend to move together, except bonds can move somewhat opposite stocks, but this isn’t a given; not to geek out too much here:)
Then ask: Are the numbers congruent with your chosen risk level?
This is step two for how to invest your money: choose your risk level.