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When And Why To Invest

Am I Ready To Invest?

Almond Confirmed MascotA little financial knowledge goes a long way. Before investing individuals should build a cash reserve. The reserve should be large enough to be able to meet two objectives.

  • The first objective should be to save enough in cash to be able to support yourself if you were to temporarily lose your source of income. To calculate this number you need to take a look at your monthly expenses (bills, food, gas, rent/mortgage, insurance etc.). This reserve is to pay for your living costs if you were to lose your job and needed cash to support yourself while you searched for a new job. The amount of months to have in this reserve is a personal choice; at minimum, factor in expenses, other sources of income and the estimated time it would take to acquire a new job.
  • The second objective should be considered an “emergency fund.” The emergency fund is ideal for costly unforeseen expenses (I.E. a large car maintenance expense). I have read various recommendations on the ideal size of an emergency fund, those recommendations ranged from 3 months to a year of pay. However, ultimately your emergency fund is a personal decision of how liquid you feel you should be in the short term.

If this cash reserve condition is met and there is left over cash that is not needed in the foreseen short term (within 12 months), then individuals have the opportunity to earn money with their money by investing. Investing excess capital is prudent because the interest rate from a savings account is very low compared to average historical returns of many simple investment options. For instance, a typical savings account may yield 1 to 2% a year or less; on the other side of the spectrum, the U.S. stock market, indexed by the S&P 500, has historically returned 10% a year on average from 1928-20171.

Furthermore, investing in individual firms allows investors to take control of their money, allocating capital to the company’s perceived to be doing the most. From concentrating on revenue growth to ranking firms by their ESG rating, taking control of the investment management process enables individual investors to back their values with their capital. Capital allocated properly can aid innovation, spark economic expansion, and directly lead to higher standards of living.

Where Do I Start?

  1. The first place to start is with a retirement account. If you work at a firm that offers a 401K plan and has any type of match program then maxing out the contribution should be the first goal. For instance, when I worked at Bloomberg the company match was 50% up to 15% of pay. So for simple math, if I was making $100K a year at the time and wanted to max out the plan then I would contribute 15% of my pay ($15K) into the 401K plan and the firm would essentially give me 7.5% ($7.5K) for a total contribution of $22.5K. Taking full advantage of a firm’s retirement contribution match is highly recommended. Take the free money.
  2. If you work for yourself or for a firm that does not offer a match program you have several retirement plan options that have various tax advantages. The two main account types are an IRA and a Roth IRA. At the most simple level, an IRA is tax-deductible (so contributions are essentially pre-tax), but the profits realized from distributions in retirement are taxed at the individuals ordinary income tax rate. On the other hand, a Roth IRA is funded with after-tax money but qualified distributions in retirement are tax-free.2,3
  3. There are penalties for taking money out of your retirement account before the set retirement age (currently 59.5 years old). However there are also exceptions to those penalties that are also worth understanding (I.E. $10K can be withdrawn for a first time home purchase), see the source links below for more details.
  4. Another option is to set up a personal brokerage account (I.E. Charles Schwab, Fidelity, Interactive Brokers, Robinhood, TD Ameritrade). This type of account would need to be funded with after-tax dollars. Any profits would be taxed at either the individual’s ordinary income tax rate (if the investment was held for less than a year) or the long-term capital gains tax (if the investment was held for over a year) which is based on the individuals tax bracket.4 The taxes paid for short term gains are always higher or equal to the tax rate paid on long term gains.

What's Next?

Next is the fun part, finally! Time to plan and then execute on allocating your investment portfolio. An ideal portfolio is diversified and structured in a way to have the right risk and reward balance for your personal needs and goals.



The CFAI defines portfolio management as an ongoing process involving:

  • Identifying investment objectives and constraints
  • Developing investment strategies
  • Making portfolio allocation decisions
  • Investment performance is measured and evaluated
  • Market and investor changes are monitored and any necessary rebalancing is implemented1

I am of the belief that the key to “making smart* portfolio allocation decisions” is through the idea of diversification. The concept of diversification is comparable to the idea of spreading your bets. It wouldn’t be smart to put all your money on one number at the roulette table, it also wouldn’t be smart to have the majority of your capital invested in one firm’s common stock. Creating and maintaining a portfolio that gives exposure to growth without accepting too much risk is a practical approach to investment management.

Diversification typically revolves around the statistical measure of correlation.  Correlation is a measure of how two sets of data move together. When constructing a portfolio, you ideally want to decrease the potential for extreme losses by allocating capital to asset types that historically have not moved perfectly together (are not perfectly positively correlated). For instance, having all of an investment portfolio allocated to stocks in 2008-2009 would have been a painful reminder that stocks tend to move together (even when invested in various sectors and geographic markets). Concentrated asset allocation risk, as just described, can be taken early on in an investor’s life because there are many years to recuperate any losses. However, as individual investors get older and get closer to drawing on investment savings, their investment portfolio needs to shift from risky to moderately risky. For instance, if an investment portfolio were constructed of 50% stocks and 50% gold in 2008-2009 the performance of the diversified portfolio would have returned superior performance to the all-stock portfolio, and would have been less volatile.

Yahoo Finance data used for the annual performance figures given.6

Gold is not the only useful financial product that can be used to diversify a portfolio. In my next post, I will outline the various financial asset types and the products used to invest in them.

First, let us take a dive into two commonly cited factors in the construction of a diversified equity portfolio, by taking a macro approach to looking at the global economy in terms of sector and country.

“Sector” in the financial world is defined as “an area of the economy in which businesses share the same or a related product or service.”2 The S&P 500 (a very commonly used benchmark for large-cap U.S. equity markets) was made up of the following portfolio weightings as of 9/30/2019:

Graphic taken from S&P Dow Jones Indices website5

A well-diversified portfolio would have at least some exposure to all of the sectors listed. The specific sector and geographic weighting allocation of a portfolio is a subjective decision; sensibly determined by a cost and benefit comparison.

In addition to sector, the countries in which firms do business is a factor of equal importance. A starting point to thinking about geographic diversification is to look at various economies by GDP size and growth. According to The World Bank’s data, the top 10 countries by 2018 Nominal GDP (Gross Domestic Product, or the final good and services produced) were as followed:4

Graphic taken from The World Bank’s website4

The U.S. is still a powerhouse in regards to GDP measurements. It is important to mention that China in particular has been rising in the ranks very fast. In 2006 China’s GDP trailed both Japan and Germany and was relatively in line with France and the U.K.; but China has grown to over 2X the sizes of those same peers a mere 12 years later.

Using The World Bank’s data library I created the following chart highlighting the the Annual GDP Growth rates for six of the previously listed countries (the largest 5 as well as India because their growth is something to keep an eye on).

Taking those economy sizes and growth rates into account, it should not be surprising to note that the U.S. equity markets have been performing well since retreating during the 2008-2009 great recession.

When creating a portfolio it is prudent to keep both sector and country risk factors in mind. It is this type of macro approach to diversification that can save investors from unsystematic risk, or “specific risk”, like the recent crypto bubble pop of 2018. However, these are not the only factors to examine when creating a diversified portfolio. In my next post, I will outline the various financial asset types and the products that can be used to invest in them.  

  1. Maginn, J. CFA, Tuttle, D. PhD, CFA, McLeavy, D. CFA, Pinto, J. PhD, CFA. (2018). Alternative Investments And Portfolio Management. The Portfolio Management Process and the Investment Policy Statement (p. 256). CFA Institute.

Core Asset Classes

Before thinking about the ideal asset class allocation to utilize in a diversified portfolio, one should understand both the asset classes available to retail investors (or “individual investors”), and the products used to invest in those asset classes. I am going to split investment asset classes into three main groupings to mentally compartmentalize; Equity, Fixed Income and Alternatives.

Equity is straight forward enough; owning a common share of stock in a public firm (I.E. a share of Apple Inc.) is equivalent to owning a portion of the firm’s net asset value. Net asset value is marked as “Shareholders Equity” on most balance sheets, and is calculated as the firm’s remaining assets after deducting for the total liabilities the firm owes. In other words, common stock is really just a certificate of ownership that gives specified economic and voting rights to the owner of the stock. Some more mature firms issue dividends for their shareholders, but these dividends are not guaranteed and could be cut or ended at any point. 

Here are several ways to invest in equity as a retail investor:

  1. Common stock: You can directly purchase and sell shares of a public company on a brokerage platform (I.E. Charles Schwab, Fidelity, TD Ameritrade, Robinhood etc.) when the market is open (9:30AM-4:00PM EST Monday through Friday, omitting market holidays). Most brokerages charge a commission for purchasing and selling (typically the commission is a flat fee, and so the amount of shares you buy or sell in a given order does not matter, the commission fee will be the same). Owning common stock directly is one of the more risky ways to invest because unsystematic risk (stock specific risk) is prevalent; this risk can be mitigated however by creating a portfolio with multiple (25-30) stock holdings that are diversified properly.
  2. Stock ETF: ETFs (Exchange-traded funds) can also be purchased using your brokerage account. An ETF is designed to hold a basket of underlying securities, with the stated objective of tracking a particular set of equities (I.E. the SPDR S&P 500 cited in an earlier graphic, tracks the S&P 500 Index).2 ETFs mitigate some of the risk involved in owning direct equity by diversifying across a multitude of stocks. However, stock ETFs are not all made the same. For instance, some ETFs invest in one specific industry, while others are actively managed by an investment team. Furthermore, ETFs may or may not have a commission for buying into and selling out of the ETF, but to my knowledge all ETFs have at least some fees based on assets invested. Fees tend to be relatively small (as low as 0.01% a year) because the ETFs are setup to passively track benchmarks; but some ETFs are actively managed and so carry a larger fee rate.
  3. Stock Mutual Fund: A mutual fund is quite similar to an ETF except it is not traded on brokerages, instead participants gain access to a mutual fund by buying into the fund at the NAVPS (Net asset value per share) through their company’s retirement plan. The CFAI defines a mutual fund as, “A professionally managed investment pool in which investors in the fund typically each have a pro-rata claim on the income and value of the fund.”1 As with ETFs, owning a unit of a mutual fund gives an investor partial ownership of the fund but not direct ownership in the underlying securities and so there are no voting rights for investors. Fees for mutual funds tend to be higher than those of ETFs because mutual funds are typically actively managed by a professional investment team; passively managed mutual funds are typically called index funds. Ideally the benefit to investors for the relatively higher priced mutual fund product is the professional grade investment management that mutual fund investment teams offer.

Fixed Income: “A fixed income security is an instrument that allows governments, companies, and other types of issuers to borrow money from investors.”1 Fixed income is really just a synonym for debt, and there are many types and characteristics of debt. Companies, governments and other entities borrow money in the financial markets by selling bonds (debt contracts) to investors. The main features of bonds are: the bond’s issuer (the entity that issued the debt), the maturity (the termination date of the bond), the par value (the amount that is paid to the investor at the maturity date), the coupon rate and frequency (the distributed income and timing of that income from the bond, that investors are promised), and the monetary currency of the debt contract.1

As a whole, the asset class of fixed income is deemed safer than that of equity, and for good reason. For instance, U.S. Treasuries are accepted as essentially risk-free in the financial markets because the issuing entity (the U.S. government) has backed them.5 But, however close to risk-free some debt can be, it is important to remember that not all fixed income is of equal quality and fixed income investing is not without risk. On the other end of the risk spectrum, in the case of corporate bankruptcy, fixed income investors are paid before equity investors are (recall debt is part of the “total liabilities” that are subtracted from the Net Asset Value equity investors are entitled to).

Here are several financial products in the fixed income retail market:

  1. Individual Bonds: “Bonds typically pay a set schedule of fixed interest payments and promise to return your money on a specific maturity date. They are issued by a variety of entities, such as the U.S. Treasury, government agencies, corporations, and municipalities.”3 Similar to owning common shares, in regards to equity investing, owning individual bonds is the most risky way to invest in fixed income because of the unsystematic risk involved. That risk could be mitigated through diversification but since fixed income securities have a maturity date (the have a set end date) the amount of continuous work to replace investments that have matured makes this option less appealing to most retail investors.
  2. Bond ETFs: There are ETFs for bonds that give exposure to a large number of underlying bond issues and track various benchmarks and or industries.
  3. Fixed Income Mutual Fund: A pooled investment fund that focusses on specific types of fixed income securities. Both active and passive funds exist and their fee rates vary.

Alternatives: The alternative investment grouping is my ‘capture-all’ for the remaining main types of asset classes. Alternative asset investing is relatively new and so a consensus definition is hard to come by. However, according to CAIA, the four types of alternative assets fall into four groups:

  1. Real Assets: “Real assets are investments in which the underlying assets involve direct ownership of nonfinancial assets rather than ownership through financial assets.”6 Real assets include natural resources, commodities, real estate, infrastructure and intellectual property.
    Commodities: “Commodities are split into two types: hard and soft commodities. Hard commodities are typically natural resources that must be mined or extracted—such as gold, rubber, and oil, whereas soft commodities are agricultural products or livestock—such as corn, wheat, coffee, sugar, soybeans, and pork.”Investing in a commodity can be accomplished through focused Mutual Funds and ETFs.
    Real Estate: Both private and public real-estate investing is available to retail investors. For instance, private real-estate investment could take the form of a personal mortgage (purchasing real-estate using debt). Whereas public investment in real-estate could be accomplished by purchasing a REIT (Real Estate Investment Trust) or by purchasing a MBS (Mortgage-backed security). REITs trade just as stocks do on public exchanges and so can be purchased through a brokerage account just as stocks and ETFs. MBSs are financial products that pool together home loans and then sell shares of the pooled grouping.

  2. Hedge Funds: “…a privately organized investment vehicle that uses its less regulated nature to generate investment opportunities that are substantially distinct from those offered by traditional investment vehicles…”6 There are many different investment strategies implemented at various hedge funds and their characteristics vary substantially.

  3. Private Equity: “The term private equity is used in the CAIA curriculum to include both equity and debt positions that, among other things, are not publicly traded.”6 This asset group includes venture capital, leveraged buyouts, mezzanine debt and distressed debt.

  4. Structured Products: “Structured products are instruments created to exhibit particular return, risk, taxation or other attributes. These instruments generate unique cash flows as a result of partitioning the cash flows from a traditional investment or linking the return of the structured product to one or more market values.”6 An example of a structured product would be a collateralized debt obligation (CDO).

While the CAIA institute does not include simple derivatives in their classification of alternative assets, I will for the sake of mental organization.

  • Derivatives: “A financial instrument whose value depends on the value of some underlying asset or factors”1 (I.E. a stock price or an interest rate). Derivatives are highly complex but commonly used in investment management to hedge risks (mitigate exposure to risk). Some brokerages gate keep derivative trading as derivatives can be a dangerous asset class; for instance, Charles Schwab required me to pass a short quiz over the phone before approving basic option-trading access. I will be focusing on the more simple type of derivatives (stock option calls and puts) in future posts.

To conclude, Equity, Fixed Income and Alternatives investments are the core asset classes I would point investors to focus on while building and maintaining a diversified portfolio. There are a multitude of ways to invest in these asset classes but the least expensive way to gain diversified exposure is likely through ETFs and Mutual Funds. For that reason, the majority of my capital is invested in ETFs and Mutual funds rather than individual stocks, bonds or alternative investments.

    1. Equity and Fixed Income. CFA Program Curriculum, 2016. Level 1. Volume 5. Glossary.
    6. Alternative Investments CAIA Level 1. Third Edition. 2015. Chambers, Donald. Anson, Mark. Black, Keith. Kazemi, Hossein.

What is in the pipeline?

Weighing risk and reward can be a daunting task. Next I will showcase some of the perceived risks of the equity markets and suggest an allocation strategy for the average investor given various investment horizons (the amount of time remaining to invest before withdrawals are taken).