OtOoI Ch. 3: Preparing Your Mind to Invest

One week ago, you fought your way through the most difficult chapter in this 5-part series. We discussed the environment we invest in, and the various investment vehicles that are available to us, including:

1. The Stock Market = The Investing Environment
2. Stocks/Equities = The Classic, The Standard, The Foundation
3. Fixed Income/Securities (such as Bonds, GICs) = The Geller
4. Funds (Mutual, and Exchange Traded) = The Team

Now that we understand the basics, I’d like to take a moment to explore more about how we invest, from a psychological standpoint. Before you put your money in the ring, you need to have a better understanding of who you are as an investor.

There are many reasons to invest. You may want to invest to make a quick buck (this is called gambling).

Perhaps more prudently, you may want to invest to get a better return on your savings than a traditional savings account, or to accumulate wealth for your retirement.

Ultimately, investing can lead to irrational, and very costly decisions if you do not have the correct mindset to invest.

Investing is inherently risky. You are putting your money on the line in an environment fully exposed to market forces. In a single day, you could make a fortune, or lose a fortune. If you are afraid of risk, perhaps you are happier with your money stashed away in a savings account, but remember that even with savings, there is risk—risk that inflation will eat away at your hard work.

The amount of risk you expose yourself to is dependent on what you invest in, and what you invest in is therefore heavily dependent on your answers to the five questions below. Additionally, risk tolerance questionnaires are available online to give you an idea about how much risk you can tolerate, or how you should allocate your asset classes in your portfolio based on your risk tolerance.

Higher risk investments are defined as having a higher risk of losing significant amounts in your portfolio, but are associated with higher returns. This is why you can make more on the stock market than by investing in low-yield bonds.

An important aside is that there is a difference between risk and volatility. A risky stock is not more or less volatile than a ‘safe’ stock. Volatility comes from market forces and investor sentiment. Risk comes from a company’s business practices, and the actual environment in which the company operates. A company that has steady returns in heavily regulated markets, like a utility company, is far less risky than a startup healthcare company in a competitive sector. Yet, each is exposed to market volatility.

In order to decide how you want to invest, you need to ask yourself the following questions:

1. What am I investing for?
2. How much risk am I able to handle on a financial level?
3. How much risk am I able to stomach on an emotional level?
4. How much volatility am I able to stomach on an emotional level?
5. Do I want to put in a lot of work to invest, or a little?

So, let’s begin this exercise in understanding our own investment philosophy with an analysis of our investment horizon.

Investment Horizon

Determining what your investment horizon is, is the first thing you need to do, and answers the first two questions we have above.

Are you investing to save money for a down payment on a house in the next 5 years? Are you investing for your child’s future education? Are you investing for your own retirement?

There are many reasons to want to save, and therefore, to invest, but the time until that money is needed is the most important factor. A general rule is:

Any money that you will need in the next 5 years should not be in the stock market.

Why?

Because stock markets are volatile, and while volatility is not typically a bad thing in long term investment horizons, it is when you need access to your money now. Your portfolio’s value can go up and down with market volatility all it wants if you don’t need that money for 25 years, but if you need your investment for a down payment on a house in 5 years, what do you do if your portfolio happens to be down 20% when you need it?

Your investment horizon is of the utmost importance in deciding what you will invest in. Imagine a typical portfolio, which may contain some percentage of stocks and some percentage of bonds. The percentage allocated to fixed income should be higher in accounts holding money needed in the near future. A good example of this would be investing in a Registered Education Savings Plan (RESP)* for your child’s education.

Example: Jim deposits $2,000 into an RESP for his newborn son, JJ’s education, with plans to contribute an extra $1,000 per year. He chooses to invest in a mix of market tracking index ETFs, and bonds.

For the first 10 years of JJ’s life, Jim has an allocation of 90% ETF and 10% bonds, as he can tolerate the volatility and risk associated with stock market exposure. The money is not needed for another 8 years.

Over the next 8 years, Jim gradually shifts the allocation within JJ’s RESP, eventually achieving 90% bonds and only 10% in ETF by the time JJ turns 18 and decides to go to university. Jim has effectively managed risk, and minimized volatility, ensuring that when JJ needs it, the RESP portfolio will not be at a 20 year low due to stock market overexposure.

*Bonus note: RESPs are a great way to save for your child’s education, as the Canadian government will match 20% of your annual contribution of up to $2,500 (called a Canadian Education Savings Grant, or CESG), bringing your total annual contribution to $3,000 with a cost of $2,500. You’ll be hard pressed to find any other investment vehicle with a guaranteed 20% return.

Mindset

If you’re going to be able to sleep at night, I find it helpful to remind yourself of one important fact, and to take on two particular frames of thinking.

First, the important fact: investing for retirement, by definition, requires a long term perspective. It is the definition of a long term investment horizon. Saving and investing for a long term horizon is going to involve exposure to risk and volatility, but the beauty of a long term horizon is that there are more years ahead to make back money you may lose on a month to month, or year to year basis.

What this means, is that when the market starts to fail (for whatever reason), remember the length of time you have ahead of you and keep calm. A dip in prices is not the time to sell**, in fact, it may very well be the worst time to sell. A loss on paper is only a real loss if you choose to realize the loss by selling.

**Unless we’re talking about stock in a company that is clearly going out of business (eg. Nortel or Enron), but this is why we diversify: to reduce systemic risk.

In fact, a dip in the market may be the very time to be bold, to increase your stake if you’ve got a chance. Why? Because, a dip in the market is frequently an emotional response to some terrifying news. This may create some great opportunities to get stocks at a great value, and that terrifying news will be but a blip twenty-five years down the line. These opportunities are only possible when you take emotion out of the mix, which can be difficult, but is made easier looking at your decisions from a viewpoint in a galaxy far, far, away. 

One of the greatest investors and philanthropists of our time subscribes to this mindset when he says:

“Be fearful when others are greedy, and greedy when others are fearful.”

– Warren Buffett

Now, for two frames of thinking that I believe will serve you well in your future.

First, don’t be dogmatic. Be flexible. Learn constantly. Don’t listen to your cousin Tommy as your sole source of investment advice. In fact, don’t listen solely to me as your source of investment advice. If your chosen strategy isn’t working for you, don’t hold onto it for dear life: FIND A NEW STRATEGY.

Read. Talk to others, and find out what is working for them. Do your research and adapt. The market is constantly changing, so you can’t expect a single investing approach to work perfectly over that long period of time between now and your retirement.

Remember rule number one: make your dollars work for you. Sit down at least once a year and figure out where you can trim the fat, and how to whip that portfolio into a well oiled machine.

Second, don’t be a speculator; be a business owner. The first business you own is YOU, Inc. Your business is in the industry of savvy investing. As the CEO of YOU, Inc., you are responsible to the shareholders (you, your family). Find ways to cut back on expenses (lower MER, or eliminate them altogether?), increase efficiencies (find the appropriate amount of time to manage your investments, or even hire someone else to do it for you?), and drive higher revenues (with intelligent investments and patience).

The second business you own, and in fact, the multiple businesses you own, are those you choose to take a stake in with your investments. The moment you purchase a share in a company, you are tied to it. If you hope to make it a short term relationship, with ideas of (hopefully) turning a quick profit, you are a speculator. If you hope to cultivate a long term relationship with a company that has solid earnings and rewards those who make those solid earnings possible, then you are a business owner. I recommend the latter of those two for a long term investment strategy with an eye towards retirement savings.

One last word of advice: there is no better time to invest than today. It’s not a question of timing the market, but rather, a question of time in the market.

To summarize today, we discussed:

1. Five important questions to ask yourself before investing.
2. How to understand Investment Horizon, and its impact on your investment behaviours.
3. A mindset of prudence, and minimizing on emotion, to help you sleep at night when your money is on the line.
4. To think of yourself as a business owner, first of YOU, Inc., and second, of the businesses you take a stake in.

Check back next Friday for Chapter 4 of On the Origin of Investing, where I will address where to save; the various containers in which you can stash your cash (hint: that Ziploc bag under your mattress won’t cut it).

Happy living,

JRM