Before I go any further, I want to remind you that I’m not a professional financial advisor, and you should just take any of my advices AS IS. Check the details in my disclaimer.
There are many questions that one should ask before investing. And hopefully, this post can let you start on the necessary thinkings.
Before you start investing your hard-earned money, the most important questions that everyone should ask him/herself are “how much can I afford to lose”, and “how much am I willing to lose”. Essentially, it’s RISK. How much risk one can take (1st question) is different from how much risk one is willing to take (2nd question). Gamblers are willing to take bigger risk than they can afford. The conservatives probably will always take an under-sized risk relative to their risk affordability. There are no right answers to these questions, but only answers that can put you to sleep soundly at night.
Very often, the answers are tied heavily to the ratio of your monthly or annual saving to your portfolio size and to your total networth. I will actually look at networth to annual saving, and portfolio (or liquid networth) to annual saving. Both of these ratios together give you a fairly good idea of your financial picture. The first ratio tells you how fast you’re increasing (or decreasing for that matter) your networth, and can help you answer on “how much you can afford to lose”. The second ratio tells you the relative importance of your savings to your investing, and lets you understand that maybe you should be focusing your energy more on savings rather than investing, or vice versa. Obviously, if the absolute numbers for savings & portfolio sizes are relatively small, then definitely you should “go back to the drawing board” and work on your savings. If your savings is relatively large compared to your portfolio AND you are young, it means that you can afford to take relatively bigger risk. If your portfolio is quite large compared to your savings, then probably you want to start to rein in a bit on your risk-taking, even if you’re young.
Here is an example. Suppose that if your portfolio to your annual savings is 10 to 1. It means that it will take 10 years of savings to replace your entire portfolio, if your portfolio goes to zero overnight. Put it another way, if your networth goes down by 10%, there it goes your entire year of savings with it. A big ratio of your networth/portfolio to your annual savings can mean two things: either your networth is quite significant, or your savings is quite insignificant. The case of having $100K networth with a $10K saving is quite different from the case of having $1K networth with $10 annual saving. In both cases, the ratio for evaluating your risk is the same, but instead of working on your investment, you may want to work on saving more money if you only save $10 a year.
To understand how your age affects the RISK tolerance, I will compare the “ratio of networth to annual savings” and “the number of working years before the retirement”. A simple comparison of these two numbers gives you a clear picture of risk relatively to your age.
For example, if your networth to your saving is 20 to 1, and you’re 5 years away from your retirement, then it’s time for some risk moderation. You don’t want to lose a big portion of it before going into retirement. If you are still 10+ years away from your retirement, you may be able to afford to take some risk since the time horizon may be long enough for any markets to recover from a big fall. In another extreme example, if your networth to your saving is 100 to 1, and you’re still 25 years away from your retirement, what should you do? In this case, I would advise a more conservative portfolio even if you’re still young. The reason is that your networth is quite big that a 20% drop of networth will require you to work another 20 years to make up such shortfall. And if you’re already into retirement, I would only put any excess money beyond the total required amount for the projected length of retirement into more risky investments. You may put more or less than the excess amount depending on your risk tolerance, but you definitely don’t want to screw up your retirement plan that has been well-executed in the past.
I always examine my networth to my monthly savings when I do my monthly networth review. The reason is that it gives me a picture how my finances are rolling forward, assuming everything else is stagnant. It also helps me to assess the risk that I can take. Whenever I invest a portion of my money into something, I always want to know what can happen in the worst case scenario. And one of the scenarios that I mentally go through is “what if this investment goes to ZERO?” How will it affect my daily life? When it goes to zero, the only thing that I can count on is my new incoming savings. Therefore, I always look at my investment transaction size relative to my monthly or annual savings. It tells me essentially how stupid I can afford to be for this time around.
Once you have done a good analysis on both your networth, portfolio and your saving rate, and have compared their sizes, and compared it to your age to retirement, you will have a very good assessment of how much you can afford to lose (relatively speaking). How much you are willing to lose should always be less than how much you can afford to lose. There are gamblers out there who will bet repeatedly on small probability events in the hope of big payout days. Oftentimes, they are either saved by their families and relatives, or by their age, or by the society through bankruptcy mechanisms. I simply don’t know any opportunity that warrants you to leverage and bet more than you can afford to lose. I guess it’s possible that a person may face such difficult decision once or even twice in their lifetime. But even when the outcome is positive, it is never guaranteed. I will always advise not to risk what you cannot afford to lose.
In fact, all the above questions should be re-assessed on a constant basis because of changes in your financial situations. You should adjust your personal finance risk as time goes on. The more difficult things are the market risks, and risks inherent in every stock selection or every real estate transaction. But sometimes (or often?), even a professional will get it wrong. There are no magic tricks for investing as I have explained in “My Advice to Preserving Wealth in 30s thru 50s“. Such magic Midas trick is self-defeating. One can pretty much devour all the money in the world through a consistent and compounding trick significantly higher than inflation rate. Since you know that’s not realistic, you know either such tricks cannot be consistent, or that they are consistent but with a return much much closer to the inflation rate.