One of the first things you need to do before investing is to plan how much of your existing wealth will go into each type of investment.
New investors tend to identify an investment opportunity, think that it is the best idea in the world and risk a disproportionately large amount of their wealth in a single venture. We do this because we are not aware of alternative investment opportunities and fear losing out on a "sure thing".
There are plenty of ways to invest your money:
Each of these has an inherent risk that usually results in a proportionate reward for the investor. None of these investments are a "sure thing", even the cash equivalents.
I personally split my wealth as follows:
New investors tend to identify an investment opportunity, think that it is the best idea in the world and risk a disproportionately large amount of their wealth in a single venture. We do this because we are not aware of alternative investment opportunities and fear losing out on a "sure thing".
There are plenty of ways to invest your money:
- stocks - equities, derivatives (options, futures), ETFs, funds, indexes etc.
- debt - government bonds, corporate bonds, direct lending etc.
- property - residential, commercial, industrial, REITs, land banking etc.
- private equity - hedge funds, crowd funding, etc.
- commodities - oil, gold, silver etc.
- cash equivalents - bank deposits, fixed deposits etc.
- insurance - term plans, investment linked plans, saving plans, etc.
- exotics - fine art, wine, crypto currency etc.
Each of these has an inherent risk that usually results in a proportionate reward for the investor. None of these investments are a "sure thing", even the cash equivalents.
I personally split my wealth as follows:
The right side of the pie shows about 50% of my wealth which sits in cash-like instruments.
The left side of the pie shows the 50% of my wealth which I allocate to active investments. The derivatives are where most of my investment income currently comes from. It is the highest risk category and hence the highest reward category of my portfolio. Notice that it is only slightly above 1/3 of my overall wealth.
As it stands, even if all my high risk investments in my derivatives were to be wiped out in a single event, I would still be able to keep up my family's standard of living for at least 10 years. So, even though I could theoretically allocate up to 70% of my wealth into derivatives and earn returns at a much faster pace, the increased risk of ruin is just not worth it.
Allocating a huge proportion of your wealth into a new investment without fully understanding it and hoping for the best is gambling, not investing.
The left side of the pie shows the 50% of my wealth which I allocate to active investments. The derivatives are where most of my investment income currently comes from. It is the highest risk category and hence the highest reward category of my portfolio. Notice that it is only slightly above 1/3 of my overall wealth.
As it stands, even if all my high risk investments in my derivatives were to be wiped out in a single event, I would still be able to keep up my family's standard of living for at least 10 years. So, even though I could theoretically allocate up to 70% of my wealth into derivatives and earn returns at a much faster pace, the increased risk of ruin is just not worth it.
Allocating a huge proportion of your wealth into a new investment without fully understanding it and hoping for the best is gambling, not investing.
Why this works
The key to successful investing is not high returns, it's survival. Warren Buffett, arguably the world's most successful investor, has an average annual return of 20.8% since 1965. Many people are able to achieve 20% returns in a single year, it's not something that is incredible. The trick is to be able to do that over and over again, year after year.
In investing, there will be good years and there will be bad years. If you are going to risk 100% of your money each time you invest, chances are, you will be kicked out of the game in one of those bad years. Splitting up and diversifying your investments prevents that from happening.
In investing, there will be good years and there will be bad years. If you are going to risk 100% of your money each time you invest, chances are, you will be kicked out of the game in one of those bad years. Splitting up and diversifying your investments prevents that from happening.
How-to guide
Record down on a spreadsheet all of your wealth, so that you can get a bird's eye view of where everything currently sits.
Make sure that you have at least 6 month's worth of expenditure covered by your liquid cash. These will only earn you the savings account interest rate, but their main value is as a buffer, so you know whatever happens, your current lifestyle will not be affected. If you are already retired, this is especially important and you might want to bump this up to 3 year's worth of expenditure to give yourself time to react in case disaster strikes. If you currently don't even have 6 month's worth of expenditure covered in cash, you might not be ready to invest. Review some of my savings tips to help you get to that point.
For the remaining amount, you will want to allocate them into various investments of differing risk/return profiles. To do this, you will first need to learn about each type of investment and the risks that each one carries. Do not put a significant amount of your wealth into any investment until you understand how much money you can lose in that investment. Slowly scale up over time as you begin to understand how each investment works.
However, avoiding any allocations at all into risky investments is also a bad strategy. I find the fastest way to learn a new investment is to allocate a small amount of money into it. This allows you to experience the emotions involved, which is a large part of investing. Just be ready to lose that amount and pay for the lessons that only actively investing can teach you.
Make sure that you have at least 6 month's worth of expenditure covered by your liquid cash. These will only earn you the savings account interest rate, but their main value is as a buffer, so you know whatever happens, your current lifestyle will not be affected. If you are already retired, this is especially important and you might want to bump this up to 3 year's worth of expenditure to give yourself time to react in case disaster strikes. If you currently don't even have 6 month's worth of expenditure covered in cash, you might not be ready to invest. Review some of my savings tips to help you get to that point.
For the remaining amount, you will want to allocate them into various investments of differing risk/return profiles. To do this, you will first need to learn about each type of investment and the risks that each one carries. Do not put a significant amount of your wealth into any investment until you understand how much money you can lose in that investment. Slowly scale up over time as you begin to understand how each investment works.
However, avoiding any allocations at all into risky investments is also a bad strategy. I find the fastest way to learn a new investment is to allocate a small amount of money into it. This allows you to experience the emotions involved, which is a large part of investing. Just be ready to lose that amount and pay for the lessons that only actively investing can teach you.