Everyone overestimates how much risk they can handle…until they lose money.
How would you feel if you saw figures in red and before your eyes your portfolio went down by 10% (or more!)?
‘Higher the risk, higher the reward’ or so they say but is it really worth losing sleep over? If not, then you are probably best sticking to safer assets.
Before you invest it is worth remembering that ideally you want to lock that money away for at least 5 years in order to allow the market’s peaks and troughs to even out.
The longer the money stays invested, the longer your money has time to compound and grow.
What is compounding? ……Your new best friend.
Compound interest is effectively getting interest on your interest that over many years increases your annual returns exponentially.
According to Investopaedia: “Compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods”.
The example they provide is:
If you invested £10,000 that compounded annually at 5%, it would be worth over £40,000 after 30 years, accruing over £30,000 in compounded interest.
Whereas, if you just left your money sitting in your savings account and the bank is offering you 0.01% annual interest, you are LOSING money because inflation (aimed at 2% a year) is eroding your money’s purchasing power year on year.
When to invest
The most powerful statement I have come across and lived by ever since is: “it is time IN the market; not timing the market”.
I am your classic ‘analysis paralysis’ patient and inertia stopped me investing for a few months until I read that and decided to take action the very next day.
However, I am not alone and a lot of people are gripped by fear of being out of control and losing money so never invest.
But if you look at it this way, by NOT investing and letting inflation eat away at your hard earned cash then you are losing money anyway? So do your research and invest in something.
If you think you can time the market then think again, even the best of the best fund managers in Wall Street still get it wrong!
To nicely summarise my point above, listen to this podcast episode from a financial advisor who spells out why it is foolish to wait until there is “less uncertainty in the markets”.
What is your “why”?
Why are you investing? What is your end goal?
Some people invest to save up for a house in 10 years time. Others invest while their child is growing up so they can then use that money to pay their (extortionate!) University tuition fees.
It does not matter what your goal is but it is important to have one so you can then put a time limit to how long that money will be locked away for.
Remember, longer the better.
Right, so hopefully now you have established your goal and now your timeline.
Depending on what your timeline is that will then determine how risky you need to play it.
If you are young, investing for +5-10 years then you really can afford to be aggressive in your investment approach.
If, however, you are approaching retirement and are depending on this investment to supplement the income you are going to draw down from to live off once you stop working – then you will need to be more conservative.
How risky your portfolio is, depends on your ratio of bonds : equities.
WTF are bonds and equities, you ask?!
Let’s find out shall we?
Bonds vs Equities
A bond is when a company (corporate bonds) or a government (treasury bonds) issue you their debt for a certain price per unit.
You buy their debt for a fixed period of time (5 years, 10 years, 30 years) and they will pay you an interest on it in return each year.
Once that bond matures, you get your money back from the company/government.
These are considered as being “safer” than equities (especially treasury bonds) because they are backed by the government, who are very unlikely to declare bankruptcy.
If you hold a higher proportion of bonds in your portfolio, compared to equities, then you have a more conservative investment approach.
Conversely, equities are stocks/shares that you buy from a company to become a shareholder.
Companies to raise money will go ‘public’ on the stock market and have fractions of itself bought by investors to get capital on their balance sheet.
In other words, equity represents “the shareholder’s stake in a company” (Investopedia, 2021).
Consequently, they are more volatile, higher risk and more susceptible to going bankrupt compared to a government; however, the trade off being that they generally produce higher returns.
A general rule of thumb that I have come across about how one determines the ratio of bonds to equities is:
100 – (your age) = % of equities in your portfolio.
If I am 30 years old, I subtract 30 from 100 to give me 70. Therefore, as a crude figure I should have 70% in equities and 30% in bonds*.
*Other safe assets exist other than bonds that you can invest in to diversify your portfolio, such as: precious metals, cash and property etc, but I shall leave that for another blog post.
Hopefully this is all starting to make some kind of sense but do not worry if it isn’t because here are 2 resources I would recommend you look at to get a better understanding of this topic:
Pensioncraft – youtube (he’s a real nerd but great teacher)
Meaningful money – spotify
There is a vast amount of information out there and I am only just getting started, so I hope to dedicate the next few series of posts on investing and what to do if you are a rookie at this!
Read this blog again and then check out my 2 recommended resources.
Then work out why you want to invest and how long you feel comfortable parting from your money for.
Why day trading and swing trading is borderline gambling and not investing.
Speaking of appetite…I’m hungry. See y’all next week!
This blog is for educational purposes only and should not be construed as financial advice. It is purely opinion-based.