Where to invest and How to allocate assets

Courtesy - The financial Literates

Where and How Much Should You Invest? A Simple Formula for Creating Your Portfolio

“I have extra money, where should I invest it?” asked a friend of mine.

“Wherever you want, as long as you know how that investment works,” I answered.

“But I don’t know anything about investing, that’s why I’m asking you,” he replied back.

“Then I guess you should invest in yourself. Buy books, attend seminars, read about investing online. Invest in learning about investing.”

“Come on. Be serious.”

“But I am serious,” I replied. “If you buy me dinner, I’ll give you a beginner’s crash course on investing.”

He fell silent. He was contemplating. And after a few seconds, he agreed.

“Good decision,” I exclaimed. “You just made your first investment.”

I know what you’re thinking. I just scored myself a free dinner. Ha! You’re absolutely right!

However, I did give my friend a crash course on investing and how to create his first portfolio. Are you curious about what I taught him? Then read on, and there will be no need to buy me dinner for this.

Before You Invest

Two things are required before you start investing. These are non-negotiable. If you can’t do them, or you don’t have them, then you shouldn't really invest, in my opinion.

• You spend less than what you earn every month.
• You have 6 months worth of your expenses as emergency fund.

Making money from investments, specially the risky ones, take time. If you can’t live below your means, and if you don’t have an emergency fund – then you’re at risk of having the need to liquidate your assets when its value is low.

So, assuming that you’re able to pass these two requirements. What’s next?

It’s time to have some fun with your money.

• How To Build An Emergency Fund And Why It Is Important

Having an emergency fund is a necessity for everyone. It’s quite common sense to always have readily available cash for unforeseen expenses.

However, despite this fact, many do not have an emergency fund. And even if they do, it’s usually not enough.

I asked some friends if they have an emergency fund and fortunately, 6 out of 10 of them have one. Nevertheless, only 2 of them have more than one month’s worth of expenses saved. Which brings us to a common question about emergency funds:

How much money should you save and keep as your emergency fund?

There is no precise answer to this question. But it’s best practice to have at least 3 -6 month’s worth of your usual monthly expenses saved. The optimal amount actually depends on the stability of your income sources. Single regular employees are usually good at 3 months but married professionals should consider having at least 6 to 12 months worth of expenses as their emergency fund.

I guess the most practical way to know how big your emergency fund should be is to answer the question: If you lost your job now or if your business closes down, how many months will it take you to find new work or start a new business?

An emergency fund is something we never really think about until the time comes when you need it. So spare yourself of the stress and avoid the unnecessary worries by building one as soon as possible.

One more thing, never think of your credit card as your emergency fund.

A few weeks ago, my car had some problems and I had to spend quite a sum for the repairs. My regular mechanic doesn't accept credit cards. If I’d taken the car somewhere else that does, I believe I would have spent more for the same quality of work. This is just one example that proves that there’s really no substitute to having cold cash when you really need it.

So how do you build an emergency fund? There are five basic steps.

• Step 1: You have to track your expenses. You need a comprehensive look at your monthly spending to determine your personal costs of living.
• Step 2: Assess your needs. Evaluate your financial status and decide how many months should your emergency fund be.
• Step 3: Decide where you’ll keep it. It usually best to open a separate personal savings account with ATM access for your emergency fund.
• Step 4: Start saving. You can initially pay yourself first, then move on towards doing other money saving activities.
• Step 5: When you reach your goal, continue saving and build it more.

I believe that the last step is very important. When you reach your goal, don’t stop and continue to build your emergency fund. There are a couple of good reasons why you should do this.

First, as time goes by, your cost of living increases – you get married, you have kids,inflation happens, etc. When these occur, your emergency fund should adjust accordingly. By continually adding more cash to your emergency fund, you can then confidently “upgrade your lifestyle”.

Second, your emergency fund can alternatively act as your investment fund. When very good opportunities come your way, you’ll have extra money that you can comfortably risk on an investment.

• The 30-Day Time Deposit

Your emergency fund is a substantial amount of money and there’s no reason why you can’t invest it. However, you can’t afford to lose any of it so the best place for that is a zero-risk time deposit.

I recommend half of your emergency fund be put in a 30-day time deposit. That way, it’s earning interest higher than a regular savings account, yet easily accessible when you need it.

Stocks, Bonds and The Money Market

How does the stock market work? What are bonds? What is the money market? What are mutual funds? What is a Unit Investment Trust Fund?

If you don’t know the answers to these questions, then you should invest in learning about them first. You don’t have to be an expert, but it’s really important that you understand them at the very least.

That’s because my rule of thumb is: “If you don’t know how it works, then don’t invest in it.”

Asset Allocation - The Age Formula

• Living below your means – Check
• Emergency fund in savings and time deposits – check.
• Understanding of various investment instruments – check.

Now it’s time to use what I call, “the age formula”.

I can’t really remember where I got this, but I’ve always believed it’s a good rule to follow. This formula will tell you how much percentage of your money should be invested in low, moderate and high-risk investments.

The formula is simple, and the rules are:

• Invest half your age in low-risk investments.
• Invest half in moderate-risk investments.
• Invest the rest in high-risk investments.

So assuming you’re 30 years old and you have P100,000 to invest (your emergency fund is NOT included here). Then your portfolio will look like this:

• 30 / 2 = 15% or P15,000 should be in low-risk investments such as government bonds, treasury bills, etc.
• 50% or P50,000 should be in moderate-risk investments such as mutual funds, blue-chip stocks, etc.
• 100 – (15 + 50) = 35% or P35,000 should be in high-risk investments such as speculative stocks, forex, etc.

And that’s it! You have now created your very first, diversified and well-balanced portfolio.

As you can see, the younger you are, the more high-risk investments that you have. This is because it is assumed that you have more time to ride the market through bad times, and you have more active income potential to recover from losses.

I hope today’s post has helped in your investment decisions and portfolio allocation.

One cannot allocate assets without thinking of diversification. If you follow my age formula – then you’ll notice that dividing your investments in low, moderate and high-risk assets is already an act of diversification.

It is important to diversify investments, or to “put your eggs in several baskets”, to minimize your risks. That is because, if ever one investment performs poorly, your other investments can hopefully, make up for those losses and still net you with a positive balance.

How To Diversify Investments

There are many ways you can diversify, but personally – I consider three factors when doing this. They are:

• Factor 1: Risk Category

The three basic types of risk are low, moderate and high. But as you become more financially savvy, you’ll probably begin to consider up to six types: zero-risk, low, moderately-low, moderate, moderately-high and high-risk.

• Factor 2: Time Horizon

Just like the risk category, there are three basic time horizons to consider: short-term, medium-term and long-term. Again, as you increase your financial I.Q., you’ll begin to assign exact years in your investments, i.e. 1-2 years, 3-5 years, 6-8 years, 10-15 years, and so on.

If you combine the two factors above, then re-categorize all the assets and investment vehicles which you may want to buy, then you should end up with a table like this:

Once you've done this, you’ll now have a “better map” on how you can diversify while following my age formula for asset allocation.

For example, for your moderate risk investments, you can diversify by investing some of that in short-term investments, some in medium-term investments, and the rest in long-term investments.

If you have P100,000 to invest, the age formula says that you can invest P50,000 in moderate-risk investments. By using the example above, then perhaps you can use P10,000 of that to join a network marketing company; put P30,000 in a balanced fund; and the remaining P10,000 to invest in a real estate investment fund.

Please note that the table above and the examples are just an illustration. Again, personal finance is personal and it’s only you who can really decide how to categorize each investment, and how much you should invest in each one.

• Factor 3: Industry Spread

The final, and usually ignored, factor is the diversification of risk among several industries and/or companies. This simply means that you shouldn’t invest in just one company or segment, but in two or more industries so as to lessen the impact of the economy to your investments.

To explain further, let’s say that you want to invest in equities or the stock market; then don’t buy just one company – buy two or three.

Moreover, don’t buy companies which belong in the same industry, instead purchase stocks which belong in different sectors.

This means if you buy stocks of Yes bank, then don’t buy stocks of another bank as your second company – perhaps consider ITC, which diversifies your portfolio to the food industry.

How about unit investment trust funds and mutual funds? Don’t they provide a good industry spread, thus a balanced and diversified portfolio?

Yes! That’s one of the reasons why many prefer investing in UITFs and mutual funds – because most (but NOT ALL) provide instant diversification of your portfolio.

However, I would suggest that you still diversify by actually investing in different funds from different companies.

This means, if you have an equity fund with BDO, and you have new budget to invest in equities, then maybe get into Philequity Funds this time, for example.

To give you an illustration of how I diversify…

For my high-risk, medium-term investments – I own 3 stocks from three different sectors, and have investments in 2 equity funds – one from a commercial bank and the other, from an investment company.

They’re all in equities if you notice, but they’re spread “like crazy all over the place”.

Re-balance your portflio

After doing proper asset allocation and diversification, your next step in making sure that your investments are optimized to your needs is to re-balance your portfolio after a certain period.

Re balancing simply means evaluating your investment objectives, and editing your assets portfolio to ensure that they are still in line with your financial goals and requirements.

This is a necessary task which you must regularly do as often as you believe necessary, but I suggest at least once a year.

Why do you need to rebalance your portfolio?

The foremost reason why you should do this is because investments don’t always perform as expected, some can experience stagnation, others can grow faster than usual, while some, end up performing poorly over time.

When that happens, your risk profile will change.

For example, let’s say you invested P20,000 in treasury bills (short-term low-risk); P50,000 in a balanced fund (medium-term moderate-risk); and P30,000 in the stock market (long-term high-risk). This means your total money of P100,000 has a risk profile of 20-50-30 (low-moderate-high).

After a year, the net value of your low-risk investments has grown to P21,000; meanwhile, your moderate-risk assets lost a little value and became P49,000; and lastly, your high-risk investments performed well and has grown to P40,000.

Your original portfolio has grown by 10% and is now worth P110,000. But if you calculate your risk profile, you’ll see that it’s now roughly 19-45-36.

If you want your original risk profile of 20-50-30, then you need to rebalance your portfolio by funneling some of your high-risk investments to lower-risk assets.

How To Rebalance Your Portfolio

• Low-Risk Assets

If the percentage is less than what you want, then consider adding “new low-risk assets” to your portfolio. If it’s more than what you want, then sell some of it and invest in higher risk assets.

• Moderate-Risk Assets

If the percentage is less than what you want, then consider adding “low-moderate risk assets” to your portfolio. If it’s more than what you want, then sell some of it and invest in lower or higher risk assets.

• High-Risk Assets

If the percentage is less than what you want, then consider adding “moderate-high risk assets” to your portfolio. If it’s more than what you want, then sell some of it and invest in lower risk assets.

Shouldn't I sell poorly performing assets?

Low-risk assets rarely lose value, they usually just become stagnant (value remains the same, or don’t earn as much). When this happens, you have the option to sell it and buy another type of low-risk asset.

When your moderate-risk assets lose value, it may be a good idea to monitor them more regularly and set a price which you would be willing to sell at a loss. My personal preference is 10%.

In our example, our moderate risk assets went down to P49,000 from P50,000. I shouldn’t worry much about that, but I have to monitor them closely. If their value goes down to P45,000 (losing 10% of its original value), then I would sell those assets to prevent me from possibly losing more.

Lastly, when high-risk investments lose value, then it’s also wise to monitor them more closely and again, set a price which you would sell at a loss. With this, I set it at 20%. High-risk investments tend to be volatile, that’s why I give them “more space” to move down.

Personal finance is personal

I’d like to remind everyone that these are just suggestions. You should always set your own “stop loss” percentages that is in accordance to your personal risk tolerance.

Adding more to your portfolio

If you need to add more assets in your portfolio, always go back and consider the advise I gave in diversification.

When re balancing try to sell off investments from over-weighted categories and funnel them to new or under-weighted categories. Also, as long as an investment is not losing money, then my advise is to just let it run its term and grow.

Lastly, always remember to invest regularly. If you have a big amount of money to invest, don’t do it in one go – instead invest in smaller, more frequent, portions so you can take advantage of cost averaging.

I hope you found my three part-series on personal portfolio management helpful. This is exactly how I manage my own finances and I hope you were able to pick up a few tips from it.