Stress is the byproduct of investing. Especially if you decide to take your financial future into your own hands. On one hand, investing is fulfilling and satisfies your curiosity; on the other hand, it can give you the constant doubt on whether you are on the right track. If you are early in your investing journey, first things first. The critical question for you to answer is: what’s your personal investment style?
Know thyself, and know thy personal investment style
Not knowing who you are as an investor is the number one common mistake in investing. It might sound a bit fluffy, but defining your investment style leads to very practical results.
Your personal situation defines your investment style
The first thing to know about yourself is an objective assessment of your personal situation. There are 2 major considerations to think about when you start creating your personal investment style:
- Your personal risk tolerance for risk
- Your financial goals
Investment style consideration 1: risk tolerance
Are you risk-loving or risk-averse? Do you drive in the slow lane or the fast lane on the way to work? Are you a red-blooded trader who loves to make short-term bets on small biotech stocks, or are you a patient value investor who loves to scoop up undervalued distressed investments?
Each person has a different propensity for risk. When investing, this risk propensity can be used to determine the percentage of your portfolio that is considered “risk-on” vs. “defensive”.
For example, if you know that volatility can cause you stress, a portfolio of defensive index funds and ETFs would make sense for you. However, if you can live stress-free through short-term volatility, then taking on a portfolio of aggressive growth stocks might be more appropriate. The practical answer is somewhere in between, depending on your temperament.
Your temperament defines your investment style
When it comes to investing, most of the time we just aren’t built for it. We have a tendency to see an order in randomness. Also, we find patterns where none exist.
Seeing patterns where none exist is harmful when it comes to investing.
Investing is a game of emotions – the less emotional you are, the better will your long-term performance will be.
If you count ‘patience’ among your strengths, you are well-suited to long-term investing where having patience can earn your outsized returns.
However, if you are prone to stress, then staying defensive with index funds and ETFs might be the better way to go.
Whatever you do as an investor, don’t go against your temperament. Doing so might end up with demoralizing results.
We have a tendency to see an order in randomness. We find patterns where none exist.
Investment style consideration 2: financial goals
The answer also depends on your financial goals. Are you investing to primarily save for retirement? Or for a new house next year?
The determines your time horizon and your liquidity needs. The longer your time horizon, the more risk you can take on.
Be objective in defining what your financial goals are and their timelines.
Examples of financial goals & investment time horizon
For example, if you are looking to accumulate money to send your child for higher education in 3-5 years, allocate a marginal amount of money (say around 10-20%) to equities. Keep the rest as defensive, liquid assets.
On the other hand, if you are investing to retire in 30 years, positioning a significant portion of your assets in equities make more sense for you.
The longer your investment horizon, the lesser the impact due to short-term fluctuations in stock prices. In the stock market, return and time are painstakingly related.
Be objective in defining what your financial goals are and their timelines.
Investment style vs. investment process
There’s a difference between defining your personal investment style vs. your investment process. What’s the difference?
Your investment style is what you would invest in. On the other hand, your investment process is the method of fundamental research and how you make investment decisions.
For a detailed discussion on developing your investment process, check out our guide on fundamental analysis.
Define your investment universe
After you’ve assessed your risk tolerance and financial goals, define your investment universe. There are many asset classes and geographies to consider. Stick to what you know.
There are 4 factors to consider when building your portfolio. Your mix of each factor depends on your risk tolerance and time horizon.
1. Asset class: stocks vs. bonds
Do you want to get higher returns from stocks, or be more defensive with bonds? Are you more excited to be a shareholder of the business, or are you more concerned with protecting the downside risks?
2. Region: U.S. vs. international
Are you want to stick to just the S&P 500, or do you want exposure to international markets as well?
3. Market cap: small vs. large
Do you love to find under-covered small-cap companies that few other people have discovered, or do you like to follow large-cap conglomerates?
4. Style: value vs. growth
Are you a Warren Buffett disciple or an Elon Musk fan? Do you want to invest in undervalued, boring “cigarette butts” or be an owner of sexy, high-flying ventures?
Write your investment objective
Institutional investors have written investment objectives. Formal investment objectives are no different from your own personal investment style.
Think about your preference for each of the 4 factors above. Write them down. This is your personal investment statement.
Why is it important to develop a written investment statement?
There are a lot of different ways to make money. There is no one categorically right way to invest for everybody. But there’s absolutely a right way for you personally. Sticking to your own way is the prerequisite to being a disciplined investor.
Investing in what you understand
We’ve talked about shaping your investment style based on your risk tolerance and financial goals, and how you should decide your portfolio mix in terms of asset classes, region, market cap, and style.
Now let’s talk about the #1 pitfall to avoid when you form your investment style: investing in stocks that you don’t understand.
You’ve worked hard for your money. Don’t gamble it on investments you don’t understand. For example, if you don’t know what are the top 20 members of a “smart ETF”, avoid it. If you are hearing an exciting pitch on a biotech stock that you have little knowledge of, skip it.
Your investment style can include multiple time horizons
Most people are investing for both long-term retirement and short-term purchases. Define your investment style for each bucket of your money that have different time horizons.
Let’s go over some examples of how you can invest for the long-term vs. the short-term.
The buy-and-hold, long-term investment strategy
Your long-term investment strategy is typically defined as 5 years or more.
Most of my portfolio is managing to the long-term. I don’t work with financial advisors, and simply buy 50% ETFs and 50% individual stocks.
I try to save every month and put money to work in this portfolio. I don’t do a lot of trades and strictly follow a dollar-cost-averaging method.
Investors often get poor returns because they trade on emotion. Working with a financial advisor is useful in this sense – they can help you control your emotions.
Once you realize how investing works – the opportunities and how to minimize your risk, it helps take the emotion out of it.
Maximize your tax advantages for long-term investing
All of my long-term investments are held in 4 different accounts, 3 of which are tax-advantaged (Traditional IRA, a 401k, and a 529 college savings plan).
Taxes can take a massive chunk of the future earning of your investments. It’s important to minimize their impact as much as possible.
I recommend maxing out your 401k and IRA. I also recommend people to buy individual stocks in their IRA accounts. Individual stocks have higher risks but also higher returns. Your goal is to maximize your tax advantages in accounts with the highest returns.
As mentioned above, 50% of my long-term investments are in index funds. ETFs are an essential component of my long-term investment strategy. About 60% of my ETFs are in the S&P 500, and 40% in international. I’m heavily invested in equities for the long haul.
50% of my long-term investments are in individual equities that I plan to hold for the long-haul. I invest in companies I use and believe in. I buy, but I don’t sell stocks very often because I want to minimize taxes.
Short-term trading has 2 disadvantages: higher taxes and it plays to your emotions.
If you hold an investment for at least a year then it is only subject to capital gains tax, which is your marginal income tax rate. I also don’t recommend to trade often, as most people tend to cater to their emotions when doing so. Trading has been where I’ve lost most of my money.
That’s all for your buy-and-hold investment style. Invest in ETFs and stocks that you understand, refrain from trading often and minimize taxes.
Your goal is to maximize your tax advantages in accounts with the highest returns.
The short-term investment strategy
Your short-term investment strategy is defined as within 5 years. Most people are saving for a home or large purchases.
For this bucket, be defensive and value liquidity highly. Don’t put 90% of your money in equities for this bucket; rather, have a large cash reserve. Equities simply have too much volatility for the short-term. You’d want a longer time-horizon to dampen the volatility.
For your short-term investment strategy, I recommend keeping your money in bond funds or a certificate of deposit (CD). They offer higher yields than the typical savings account.
Summary on your personal investment style
I challenge you to think about your risk tolerance and financial goals objectively. Think through the 4 factors of your investment universe, and what your mix should be for each. Write down a personal statement to define your investment style. Classify your assets into long-term vs. short-term investment strategies.
Please remember that I am not a financial advisor and that guide is meant to educate. Investing comes with risk, and I hope this helps you to become a more successful investor for the long-term.
Good luck, and post any questions below!