So I get this question a lot, "what should I buy?", as if there is a stock that I know about that’s going to go up 350% tomorrow. This is a loaded question because that question is like skipping ahead to the middle of the book without learning about the background, the characters, the plot or the author. The first thing you should really be asking is, "what do I want to do with this money?" Money is a vessel for experience, stability, and growth, not just a number in your bank account. First you should establish what your goals are and where you want to see yourself financially in one, five, ten, twenty and maybe even thirty years out. And after you figure out what your goals are, then you need to start budgeting to see how much you can invest. You probably shouldn't invest before you budget because the budget will tell you how much you can live off of and give yourself some short-term financial stability. A good rule of thumb is to make sure that you have six to twelve months of living expenses saved up so that you have a buffer in case you lose your job or have to spend time at the hospital. You never want to put yourself in a position where you need to sell in order to make rent or make a car payment or pay for groceries. You’ll get hit with taxes and there’s a pretty big chance that you’ll take a capital loss too.
After you figure out a budget, and let’s say you can invest 20% of your income, now you can start to look at what’s out there to buy. So let’s break your goals down into some time horizons. When you look at risk and reward, what you should be focusing on is your time horizon. Your time horizon is how long until you will need the money for the experience (vacation with the family), the stability (retirement), or the capital growth (that sweet new Miata). A simple goal that many strive for is: to reduce volatility while increasing expected capital gain. Volatility is a component of the risk that, at the end of your time horizon, your return will be different than the past. So, let’s talk a little about time horizons:
Under Three Years
Most advisers would probably say that if you plan on spending this money in under three years, you should just put it in a savings or a money market account because the market tends to fluctuate dramatically in time periods under three years. In statistics speak, Standard Deviations for this time horizon can be very large. So if you’re in college right now and you have money invested for rent or living expenses after school, you may want to consider selling assets that have posted a gain, and hang onto the assets that haven’t produced a return yet. If you've been sitting on a pile of cash, it might be a wise idea to just keep it there.
Short Team Goals
Short term can be anywhere from 3-7 years but it really depends on what you’re looking to do. Usually goals in this range tend to be about vacations, car purchases, or down payments on houses. Everyone usually jumps to ETFs as a solution for your short term diversification needs (I most certainly did) but after some research I found that there are lot of things to consider before using that tool. Not all ETFs are created equal. You have to be very careful with them because they are not a “one-size-fits-all” solution. Many ETFs and Mutual Funds may pass trading fees onto you (the client) as they rebalance and readjust your portfolio. They also don’t always do what the title of the ETF says it does. Many funds have generic titles like “Mid-Cap Growth Dividend” or “Large-Cap Value Blend” but the holdings of the fund may not always reflect that. You need to do quite a bit of research on what you’re buying if you plan on doing this yourself.
The chances that your investments will have lost you money in ten years are slim, but that possibility always exists. You may want to consider a blend of growth and value large cap stocks. Large cap stocks are any company that has over $10 billion in cap. The cap (Market Capitalization) refers to the amount of stock that the company has out there multiplied by the share price.
Above is market capitalization on the x-axis and employees on the y-axis.
The larger the cap or Market Capitalization, the higher the tendency for lower volatility, and more stable returns. I’ll be talking about the difference between growth and value companies in an article to come.
Mid Term Goals
This time horizon allows you to take on a little more risk. This means that you can probably have a few more stocks in your portfolio than bonds. You might want to look at a few more growth stocks and a few more mid-cap companies. Mid-cap companies are considered anywhere between $2 to $10 billion. You can use stock screeners like this one from FINVIZ. You can search based on capitalization, and this will let you find companies that might be a little riskier in the short term, but may provide a bigger capital gain in the future.
Long Term Goals
This is where you might want to think about putting some of your money in small-cap companies, anyone with less than $2 billion in market cap. These companies carry more risk, but the growth prospects are much higher because large and mid-cap companies don’t have a lot of room to grow and so their stock prices will move much more slowly and with less magnitude than the broad market. Again, this isn’t a science and these are generalizations, but the longer your time horizon, the more risk you can take.
The most important thing that you are going to want to consider here is that the portfolio that you make today will not be the one that you retire with. Life happens and your risk tolerance, time horizons, and objectives may change mildly or dramatically. That is why it’s such a good idea to have an investment adviser sit down with you and start a plan early. The good ones will ask you to come back every year and a half or so and make sure your plan is still working for you, and if it isn’t, then they’ll know how to adjust it to fit your needs. Find someone you trust and who has a track record of success. And never forget that investing is a dynamic game, not fire and forget.