The stock market has been pretty volatile since mid-February, triggered by rising 10-year treasury bond yields. New investors who jumped into the market at all-time highs might feeling anxious and fearful of further declines especially in high-flying tech stocks.
If you have a solid foundation in place, you should be able to ride through this volatility without breaking a sweat. After all, the S&P 500 and Nasdaq are only down 2% and 9% respectively from their all-time highs.
In this post, I’m sharing 5 basic things I think every investor should consider before putting any money to work in the stock market. These are based on my own research and personal experience fumbling through the stock market on and off over the past decade. They are:
- Getting your personal finances in order
- Formulating your investment goals
- Understanding your risk profile and risk tolerance
- Creating an asset allocation plan
- Paper trading and/or back-testing
Disclaimer: I’m neither a professional financial advisor nor do I work in the finance industry. I’m just a retail investor sharing my thoughts and experience from years of investing mistakes. This is not investing advise. Always do your own due diligence.
Getting Your Personal Finances in Order
Insure against unexpected expenses, set aside funds you expect to need within the next 10 years, and reduce high-interest debt. The last thing you want is to have to sell your stocks early to fund unexpected expenses, thus not allowing it to realize its long term potential.
Insurance
The main purpose of insurance is to protect against unexpected expenses that could wreak havoc in your finances. Large hospital bills can arise from unexpected accidents or illnesses. Besides the one-off costs, permanent disability or chronic illness might result in heavy long-term financial costs.
Health/hospitalization insurance is a must-have. Life insurance and accident insurance are also important to consider. If you own big ticket items like a house or car, it is worth considering getting those insured as well. Not a recommendation, but if you haven’t gotten any insurance definitely seek advise from a professional financial advisor or insurance agent.
Emergency Funds
Insurance won’t cover all scenarios, so you should still set aside funds for other emergencies. General guide is to set aside 6-12 months of expenses. Life can and will throw you curveballs.
Reduce High-Interest Debt
There’s no point trying to earn investment returns when you just end up losing it to fund high-interest debt. Reduce or better yet eliminate any high-interest debts like credit card debt, personal loans, etc. Home loans, car loans and student loans usually don’t carry ridiculously high interest rates so these can be paid down gradually to help manage cash flow.
Formulating Your Investment Goals
Are you investing for retirement or for short-term trading gains? Personally, I’m investing for retirement so I have a long-term horizon, i.e. 10-20 years. Your investment goals will help in determining which asset classes to consider and how much time you have to recover from potential market corrections.
I can’t say much about short-term trading because this is not my objective, but I can share some stats on long-term investing. From the chart below using Portfolio Visualizer showing the historical returns of the US stock market, you can see that the long-term trend for US stocks over many years is up. However, keep in mind that corrections can be significant in the short- to mid-term, and in some cases may take years to recover from.
Understanding Your Risk Profile and Risk Tolerance
Don’t risk what you cannot afford to lose. An important part in investing for the long-term is being able to ride through the inevitable volatility in the stock market. If you can’t sleep at night worrying about your investments, that’s a tell-tale sign that you’re taking on too much risk.
Understanding your risk profile is a key step in the next step of determining the proper asset allocation for your portfolio.
Risk Profile
Conventional wisdom is that your risk profile should minimally be dependent on your age or years to retirement. The longer your runway or investing horizon, usually means you can afford to take on more risk. Other factors could include life stage, whether or not you have dependents, income stability, etc. As you can probably tell, risk profile is pretty specific to your individual situation and not a one-size-fits-all.
Generally, most institutions use risk profile questionnaires to categorize investors into broad categories like Conservative, Moderate, Aggressive (and levels in between), so you can use these categories as a very rough guide.
Risk Tolerance
In other words, your threshold for pain. This is intangible and not obvious to each individual’s situation. Can you withstand a 20%, 30% or even 50% drawdown to your portfolio without selling out?
Of course asking yourself hypothetically is totally different from when reality hits, but at least you can try to mentally prepare yourself to withstand the pain. As you go along in your investing journey and better understand your risk tolerance, you can always adjust the proportion of risky assets accordingly.
From the chart below using Portfolio Visualizer showing the historical drawdowns of US stock market, you can see that the US stock market has experienced multiple drawdowns since 1972, some as much as 40-50%. Also, 10-20% drawdowns happen a lot more often than you probably think or care to remember.
Creating an Asset Allocation Plan
An initial asset allocation plan doesn’t need to complicated. Even 50% equity 50% cash is a plan. Without a plan, you might be more easily distracted and stray from your intent especially when volatility hits. A well-thought out asset allocation based on your risk profile and risk tolerance can save you a lot of sleepless nights.
Some argue that asset allocation is the most important determinant of portfolio returns, which to a certain extent can be true. 100% cash has a significantly lower chance of outperforming 100% equity over the long run.
Asset allocation is a whole topic on its own. So without getting into the nitty-gritty, you should first determine which asset classes you want in your portfolio (e.g. equities, bonds, real estate, commodities, cryptocurrencies, etc) and subsequently what proportion each asset class would take up in your portfolio.
Portfolio Visualizer also has a Portfolio Optimizer to find the optimal portfolio allocation based on your asset classes, and return vs volatility expectations. In my opinion, this is optional if you’re just starting out but definitely worth checking out later on.
If you need ideas on possible portfolio asset allocations, check out Portfolio Charts. It’s an awesome site listing several portfolios recommended by professional money managers (publicly available) and includes plenty of stats to analyze them. Can be a bit of a rabbit-hole so try not to get too caught up in all the possibilities and analysis.
Paper Trading and/or Back-Testing
Many online brokers now offer paper trading accounts where you can try out the platform and trade with fake money. I primarily use paper trading accounts to familiarize myself with the platform, but I realized that paper trading can also be a great way to test out your investing strategy before committing real money.
Of course without actual ‘skin in the game’, you won’t likely be able to simulate that same gut-wrenching feeling when your portfolio crashes by 50%, but it’s the next best thing.
Another way to refine your investing strategy is to back-test it. This brings me back again to Portfolio Visualizer, which has a nifty tool to back-test portfolios. Do check it out and play around with it.
Of course historical performance is not a predictor of future performance, but it can be a good guide and aid our understanding of how our portfolio might perform and respond to different market conditions.
Closing Thoughts
“By failing to prepare, you are preparing to fail.”
Benjamin Franklin
Investing is a multi-decade endeavor, so it’s important to prepare for the journey. Execution is another thing, but by making the necessary preparations, you are increasing your odds of success.
I hope you find this brief post covering the basic preparations before investing useful. This is definitely not a comprehensive guide, but just sharing what I’ve learnt the hard way over my few years of investing experience. If it helps to smoothen your investing journey or avoid costly mistakes, my objective is met.
I’ll be delving deeper and sharing more details on the five topics mentioned. If you’re interested, do sign up below to get notified whenever I publish a new post. Cheers and may the odds be in your favor!