Posted in Investing, Personal finance

Emotional Investing

How are emotions and investments linked? Or should they?

The two are actually intricately linked in our financial lives.

Emotions define investments, and investments define emotions. 

For example, most people who invest in stocks buy the next stock based on hot tips, be it from the last night party or the media channels doling out expert advice on stocks.

Or even the general euphoria about the economy and stock market makes us greedy and plunge into get-rich-quick behavior.

Thus an investment is made based on emotions for most people.

Now the same investments cause further emotions. The stock market is down, there is a trade war with China, the media is predicting a crash and so on.. We give in to the noise around us because we are now invested in the market, and it is our duty to become emotional with the world. Otherwise we are deemed too careless about the investments we made so emotionally.

Proven? – Emotions define investments, and investments define emotions. 

However the above linkage can be controlled and severed at the right place to make it advantageous to long term investments.

There are only 3 steps to build a successful investment strategy.

  1. Take your emotions into account in planning your investments and portfolio. See which areas of your financial life needs more focus, be it retirement, kids education, emergency fund or long term wealth. This is where most of the emotions should be used (as every one has different life goals and situation), but this is planning only – not yet buying any investment product. 
  2. Once you have decided what to invest in and how much, automate your plan. All banks and brokerage services provide automatic transfers and investments.
  3. Take rest of your emotions elsewhere. Just forget the investments as they build up. You just need to tweak it once a year. However this is where people pour in maximum emotions as the noise in the market and the economy rise and fall. Instead hold your investments for the long term as if the account is locked, and you forgot the password.

Note that after step 1, there is no more emotion.

Here are few previous posts on step 1.

Budget – Grow the tree upside-down

One essential comfort zone

Investing in the High Five portfolio

For step 2, where you take action.

Shun that perfection

Emotions are used to our advantage to plan the portfolio and then automation and ignorance (to the market) is the bliss. 

For step 3, the following quotes by Warren Buffet will help.

“If you cannot control your emotions, you cannot control your money”

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

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Posted in Personal finance

Shun that perfection

One of the lessons we learn in our early childhood is to be perfect in whatever we do. We were told if you are not perfect, you will not be able to compete in the real world. 

While it may be true for some disciplines like music, medicine and mathematics (the only subject in our times in which we could score a perfect 100/100), personal finance needs an opposite attribute.

There is nothing perfect about investments, budget and savings.

Things change rapidly like the stock markets fall when a leader in some nation sneezes, or unexpected events in life happen.

While the perfectionists among us keep waiting for the sun, moon and the earth to align to begin to invest or budget. Some of the common quotes which I am guilty of uttering at many times in my financial life.

“I will invest once I get the next raise” – when and who guarantees that today?

“I will save from next fiscal year” – hello, which fiscal year and which month does it start?

“I am too scared as the markets are going down”  – which means I will invest when they are up, exactly at the wrong time.

The end result is that the perfectionist gets a perfect ZERO in his/her investment and savings goal. 

You have to unlearn the perfections and not apply them at all in personal finance.

What is important is to get started and be consistent. 

Anyone who has not yet started or planned own finances should do this in below 3 steps.

  1. Budget – Keep it simple by following the methods described in : Budget – Grow the tree upside-down
  2. Invest – Slowly build the 5 account portfolio. Start today with at least one of the accounts : Investing in the High Five portfolio
  3. Save – Save for your important goals even if you allocate just $50 to one goal today : One essential comfort zone

Perfect plan? Now execute it imperfectly by just getting started.

Write one goal each of budgeting, saving and investing for this week. 

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Posted in Savings

One essential comfort zone

There is one cushion or comfort zone that you don’t want to get out of.

Everyone knows the importance of saving that cash. No I am not saying investing but just plain boring savings in a savings account.

Sometimes this is done as a byproduct of spending less in a month, which means there is some surplus left after you pay yourself and pay your bills, including the credit card.

However this surplus does not stay for long, as invariably next month it gives you a good feeling and you say “what the heck” – I spent less last month, so let me overspend a little this month. Hence it just disappears in next month’s bills.

Like investing, it is important to plan for savings too. The cash required to be saved is for various reasons, like a rainy day, home maintenance, car maintenance or even bills to be paid at the end of the year such as insurance and taxes.

According to Dave Ramsey, you should be in a position to pay cash for everything, except for buying a house or investment property.

How to build the required cash cushions

The blog post on budgeting talks about how you can partition your paycheck to investing, expenses and savings.

The savings part can be divided into four important goals.

  1. Emergency Fund
  2. Maintenance Fund
  3. Obligation Fund
  4. Leisure Fund

The Emergency Fund

This is for that unforeseen day when things will go wrong despite your best efforts to prevent them. It can be medical emergency, job loss, the damaged roof or the HVAC stopped working. These all can be high valued expenses, and if there is no reserve it will cause much financial distress and debt.

The general notion is to maintain 3-6 months of expenses in a savings account.

Since this money is not intended to be spent in short term (and as long as there is no real emergency), there are two important aspects.

  • The savings need to be in a separate bank account than your normal day to day checking account. In fact, it is best kept in an online money market savings account (FDIC guaranteed) to earn a little more interest than a plain vanilla savings account.
  • It should be difficult to access that account for day to day expenses and should require a special trigger (a real emergency) from you to transfer funds back to your regular checking account.

Just like pay yourself first, keep transferring a quarter of your savings goal to this account every month, till the 3-6 months reserve is built up.

The Maintenance Fund

This is the catch all maintenance reserve. It is important if you own a home or car, or even expensive gadgets that will require maintenance.

This account can be maintained in a separate savings account but in the same institution where your checking account is, so that small maintenance tasks can be serviced easily.

You should be able to move funds in a matter a seconds from your maintenance savings account to the checking account, to pay for repairs etc. or pay the requisite credit card balance arising due to the maintenance expense.

The Obligation Fund

The Obligation Fund is actually part of your expenses but not monthly paid out. There are those bills that hit us at the end of the quarter or year, for example HOA bill, Property and Income Tax, and Insurance premiums.

It is a good idea to pay as much of your bills every month, but in some cases you may get a good discount paying it for the entire year in advance. I mostly pay the car insurance and home insurance (bundled together with one provider) annually to get a special discount.

This requires me to save up for the next year’s premium in advance. The best way to build these savings, is to divide the expected amount by 12, and keep stashing away as if you are paying a fixed bill every month.

This account can be maintained in yet another separate savings account than your checking account. Or better is to save this in a money market savings account since you know when exactly you need it, and it can accumulate some interest in that time.

The Leisure Fund

The Leisure Fund is the one which helps you save for vacation, indulgence, or plain simple fun spending.

It is same as an Obligation Fund – think about it as an obligation to yourself.

For me, visiting India every summer is a priority and hence a part of this fund is allocated to save up for the expensive airfare.

This account can be maintained in a money market savings account since you know when exactly you need it, and it can accumulate some interest in that time.

Conclusion

In this post, I have presented a simple plan how to be prepared for unforeseen events and short term obligations.

Action

Automating the bank transfers from your main checking account will build these savings in no time. Also as you spend according to the purpose, the automatic transfers help keep replenishing the savings month after month. 

Here are some recommendations for bank accounts for the above 4 savings goals. I personally use the Capital One 360 Savings and Money Market accounts.

Best Online Savings Account – Top 10 Banks to Start Making Interest Today!

 

Posted in Investing

Investing in the High Five portfolio

What does investing mean to most people? Investing can be as complex or as simple as one wants to make it.

There are many theories for constructing a portfolio and it is not easy to ascertain which would work for one’s financial situation. Some common ones which are taught by most financial advisers are as follows.

  1. Risk/return trade-off achieved with diversification. 
  2. Goal based portfolio – retirement, education, short term, passive income. 
  3. Age based asset allocation. 
  4. Robo advisor created portfolio. 

The result is that one ends up creating multiple portfolios out of haphazard investments. The portfolios are also spread across multiple accounts as one’s financial life builds up.

As the accounts and portfolios spring up at different times, they lose the meaning of the overall asset allocation and financial goal of the person. There is no common theme or string to bind these accounts or portfolios together.

Here I present a 5 portfolio approach if you have multiple accounts and assign a meaning and goal to each. I have faced this dilemma and this solution/characterization comes from my own personal investment analysis.

This analysis assumes a person like me who is still 15-20 years from retirement, has children going to college in next 4-8 years and a starter in real estate and wealth building strategies.

The Portfolios

P1: 401k – The All Equity Portfolio

Term: 15-20 years

Most working people will have a 401-k or  IRA plan.

401-k has two very important kickers to deserve an All Equity portfolio.

  1. Long term – You cannot withdraw money before age 59.5 without penalty. This forces you to be committed for long term, which is good for holding equity. 
  2. Tax deferred – The contributions and earnings grow tax deferred, hence can compound tax free for a long time (till withdrawn).

Hence it makes sense to hold a predominantly equity portfolio, since equity investments are known to minimize loss and provide best returns over a very long term.

For example, one can be invested in just 3 index funds in a 401-k. You can find similar funds in your own 401-k plan.

  • Large Cap Blend (Growth and Value) Index Fund
  • Small Cap Blend (Growth and Value) Index Fund
  • International Index Fund

If you have Roth 401-k or Roth IRA, treat them as same although the restrictions of withdrawal are slightly more flexible in a Roth IRA. See the link below for a discussion on the topic.

Roth 401-k vs Roth IRA – which is better?

P2: Taxable account  – The Diversification Portfolio

Term: 7-10 years

The second portfolio is also long term but not restricted. It is created to accumulate wealth and then use it for any long term purpose.

This gives one the flexibility to withdraw it for early retirement, kids college, medical emergency or any other unforeseen circumstances. Or simply to buy a new house or invest further into real estate. 

This portfolio can be maintained in a taxable account with any brokerage firm. Although it is not tax deferred or tax shielded, it’s purpose is flexibility and use of the money in a medium to long term.

The characteristics of this portfolio is to hold a mix of different investments (low cost index funds or ETFs) which provide diversification across market caps, asset classes and risk/return profile.

It can also be optimized for tax savings if you design it that way, but then the goal is steady appreciation and not necessarily just tax savings.

This portfolio can be constructed using following types of index funds.

  • Total US Stock Market Fund (or S&P 500) 
  • Total US Bond Market Fund
  • Emerging Markets Fund
  • Global Real Estate Fund

One can add more mix and diversification to this portfolio, for example, International Developed Markets Fund or a Commodity Fund.

If the 401-k already has a sizable allocation to International Fund, this portfolio may not have one but gravitate towards more exotic ones like Emerging Markets, Global Real Estate etc.

P3: Special accounts – The Stable Portfolio

Term: 4-7 years (or custom)

This portfolio is for special purposes like kids college savings, medical savings and so on.

These are some important and unique goals, which needs both appreciation yet reasonable capital preservation. In this portfolio to gain steady returns, there can be a perfect balance between equity and bonds. 

For example, a 529 (kids college fund) and Health Savings Account portfolios can be simple:

  • Total Stock Market Fund 
  • US Treasury Bond Fund 

Typically a 50-50 allocation in two funds is good enough.

P4: The Daredevil – The Risky Portfolio

Term: 10+ years (longer the better)

This portfolio is not for everyone, but for people who are keen on more sophisticated investments in search of that extra kick (either the return or in your life).

This portfolio needs active monitoring and work to pick the investments. This portfolio has the potential for total loss, but at the same time may generate very high returns. 

For example, these two accounts below can form part of this portfolio.

  • Fundrise – Real estate crowdfunding 
  • Robinhood – Buy and hold individual stocks – dividend yielding and growth/value stocks at zero commission

However one can invest in a variety of similar high yield, high risk investments, for example, PeerStreet, YieldStreet etc.

P5: Cash Account – The Safety cushion

Term: 1-3 years

This is the most essential one to provide peace of mind. This account can be a high yield savings account or a FDIC insured money market account.

This portfolio serves two purposes.

  1. Emergency Fund – This is typically 3-6 months of expenses stashed away for a rainy day. 
  2. Cash for next opportunity – This is money you save for down payment on a house, or next investment like buying a rental or invest more in stocks when the market tanks. 

Any good online bank provides these savings account with reasonable yield.

Click here for a list of such savings options. 

Conclusion

The budgeting technique described in a previous post can help one allocate investments to all these portfolios.

So what do these P1 – P5 portfolios achieve?

  1. Purpose and time horizon
    • Assigns a purpose to each portfolio and defines its contents
    • Assigns different time horizons according to requirements/goals 
  2. Asset Allocation
    • Diversifies across different types of asset classes, yet keeps each one simple (2-4 funds) 
    • Right fund allocation according to risk appetite and age or financial situation. 
  3. Easier tracking 
    • Tracking and action is based on the particular portfolio, for example, when market goes up or down, not all portfolios need to react
    • Each portfolio can have a separate target growth number

Now give a High Five and start investing in the High Five Portfolio.

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