In our earlier posts, we talked about aiming to have a $2 million net worth by 40 with a large portion coming from building an investment portfolio of $1.2 million. It’s going to require monthly savings compounded at 6% annualized returns. Before we share with you what we’re investing in, here’s our investing strategy to avoid losses:
1. Invest early and regularly (“dollar cost averaging”)
We invest our savings monthly so that we can put our money to work right away. Over time this forces us to invest in all market conditions good or bad and hopefully avoid any bad decisions we could possibly make from trying to time the market at the wrong time.
2. Don’t put all our eggs in one basket (“diversification”)
We would never put our entire life savings in one stock. Since we have no clue what stock, sector, country will be the leading performer each year, we literally invest in all areas so we increase the chances that we’ll be right more than we’re wrong. In other words, even if we have a few companies that go bankrupt, we’ll be okay because we have other companies that are doing well enough, to hopefully offset any losses.
We allocate our stocks:
– Across different companies
– Across different sectors (Energy, Real Estate, Financial Services, Technology, Health Care, etc.)
– Across different countries and different currencies (both developed and emerging markets)
3. Only take risks with the greatest chance of rewards
There’s a lot of satisfaction that can come from stock picking but it often comes with more risk than we can handle. Stock picking exposes us to two kinds of risks:
a) Systematic Risk (Market Risk/Beta Risk)
A lot of the stock’s price is driven by how the market and economy is doing. For example, during the 2008/2009 recession, real estate prices dropped, people defaulted on their mortgages, banks went bankrupt, and people started to spend less in all areas which negatively affected all stocks to varying degrees.
b) Unsystematic Risk
The other factor affecting the stock’s price is driven by the uncertainty inherent in a company or industry investment. Types of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in (think what Apple did with their iPhones to Blackberry which caused their shares to fall from over $150 per share to less than $10 per share), a regulatory change (which could make a lot of marijuana stocks become worthless), a change in management, and/or a product recall (think Bombardier for not delivering brand new streetcars and subway trains to the TTC that work after repeated delays and recalls.)
Historically the stock market has appreciated by 4 to 6 percent above inflation per year. This makes sense because people will not invest in the stock market if there wasn’t that additional premium for taking on the added risk. For example, the S&P 500 (a measure of the largest 500 publicly traded companies in US/US stock market) has grown with 9% annualized returns from 1871 to 2018 even after some major companies filing for bankruptcies: Lehman Brothers (Asset value: $691.06 billion), Worldcom (Asset Value: $103.91 billion), General Motors (Asset value: $91.05 billion), Enron (Asset Value: $65.5 billion), Chrysler (Asset Value: $39.94 billion).
We’re serious about retiring by 40, so we aren’t going to take the additional unsystematic risk that comes with stock picking because we have no clue which company will screw up next. The consequences of being wrong is 100x worse than the benefits of being right. Instead, we’ll be extremely happy investing in the overall stock market and being exposed only to market risks and market returns.
4. Pick the cheapest investment products
Studies have consistently shown that over 80% of the time, investment products with the lowest fees almost always outperform the equivalent investment products with higher fees . A lot of this is driven from higher transaction fees, salaries, taxes, and other costs that often come with managing high fee investment products which often don’t outperform the market after fees.
We only invest in index funds which allows us to own almost all the major stock markets in the world at a cost of less than a penny per year for every dollar invested. Index funds generally are very low in fees compared to more actively managed funds because the fund company running it doesn’t have to spend an outrageous amount of money on researching companies or incur a heavy amount of trading costs. They just have to own a portfolio of stocks in the same proportion as the stock market it’s mirroring. We’re simply satisfied with earning market returns without paying an outrageous amount fees.
5. Stick to a target asset allocation of stocks and bonds
Since we know the stock market goes through cycles of ups and downs, we don’t invest everything in the stock market. We invest 60% of our money in the stock market and the remaining 40% in investment grade Canadian government bonds so that when the stock market falls, we don’t panic. We have money tucked away in bonds (money we lend to the Canadian Government) that generally go up in value when stock markets fall. As the stock market falls, investors rush to get their money out of the market and they need to invest their money in other safer alternatives such as bonds which push the prices of the bonds we’re holding up. In this scenario, our portfolio will likely have less than 60% in stocks and more than 40% in bonds.
We’re silently smiling because we’ll be selling them our bonds and can use the proceeds to buy stocks at a steep discount to bring our portfolio back to a 60% stock/40% bond allocation. We think of bonds as setting aside money to allow us to go boxing day shopping so that we can be super greedy with our purchases when others are fearful after stocks have dropped 30 to 50% in value.
We do the exact opposite when the stock markets are soaring. We sell our stocks to bring our allocation back to a 60% stock/40% bond allocation. This may seem counter intuitive but it allows us to lock in our gains and move a portion of it over to bonds and we’ll redeploy a portion of our bonds back to stocks when our allocation deviates from the 60%/40% split.
Using a target asset allocation allows us to invest on a systematic approach instead of emotions which over time ensures we continue to stay invested no matter what’s going on and this will allow us to meet our investment goal.
This was a super long post and if you got through it all, you were able to see some of the building blocks to our investing strategy which we are confident that if we stick with it, it’ll help us get to our investment goal with less bumps along the way. Hopefully you can apply some of it to your investing goals!