After teaching my “Saving and Investing 101” class at the University of Rochester yesterday, two undergraduate students ask me personal investing questions:
- “How should I invest the money in my Roth IRA?”
- “My portfolio is currently in 7 stocks, all tech stocks. My dad thinks I should diversify. Should I? And how do I do that?”
I bet you’ve had similar questions before. Investing is a confusing topic.
Thankfully, many personal investing questions have a similar answer. So whenever anyone asks me for specific investing advice, I go over the following ideas.
It’s About *You*
Giving personalized investing advice can only occur after understanding the investor. One idea I shared with the class yesterday is:
“If 100 college students asked me how to invest their Roth IRAs, I know this: I would eventually tell most of them that a diversified stock portfolio is an ideal place to start. They’re young with long investing timelines, and the higher risk/reward aspect of stock investing makes sense for them.
But, some of those 100 students might need completely different advice based on their unique circumstances. Telling the whole group, “Invest in stocks,” would be a disservice to some individuals. That’s why personalized investing advice should come after – not before – understanding the individual investor.”
Goals, Timelines, Risk Tolerance
How, then, do we determine the specific investing advice for individual investors? How do we “understand” or “get to know” them?
You need to understand their goals and risk tolerance.
A financial goal is a combination of an amount of money and a timeline for a specific purpose. E.g. “I need $1.5M by 2035, because that’s when I want to retire.” The amount and timeline provide concrete numbers from which we can do objective math.
Risk tolerance is a bit harder to pin down. It’s personal and emotional. To unwrap someone’s risk tolerance, it helps to ask questions about their investing past (“Have you lived through bear markets or crashes – how did it make you feel?”). Short of that, running through hypotheticals can help (“If your account dropped 30%, but you knew it would likely recover in ~3 years or less, how would you feel?”). There are also many risk tolerance quizzes and questionnaires on the internet.
The goals and timelines lead to a math-based, objective investment recommendation. Short-timelined money should be invested in low-risk, low-reward assets, and long-timelined money in high-risk, high-reward assets. This is the basis of “bucketing your money.” If (or when) your goals change, your investment allocation should change too.
Risk tolerance adds a subjective, psychology-based aspect to an investment recommendation. Perhaps the math alone points an investor toward an 80% stock, 10% bond, 10% alternatives portfolio. But if they’re incredibly risk averse, that 80% stock allocation will turn their brain to mush when a bear market hits. (Not if a bear market hits; when.) A more conservative allocation would help their mental health.
How conservative? It’s impossible for me to say. It depends (!!!) on the person. There’s a balance between the math (can you hit your goals on time?) and the psychology (will you be able to sleep along the way?).
The crux of investing is not creating a Scrooge McDuck pile of gold.
Instead, investing is about maximizing the odds of achieving your financial goals while minimizing your sleepless nights.
Back to the Students…
How should the first student invest her Roth IRA?
Assuming her Roth IRA money is purely for retirement**, I think an 80-100% diversified stock allocation makes sense. A total market index fund would be a good choice.
**Most IRAs are. Withdrawals before age 59.5 are penalized. They are retirement accounts.
How should the second student diversify away from her 7 tech stocks?
This one is more nuanced. First, the money is not in an IRA. It might have a short-term timeline associated with it. She and I discussed this. The money is all long-term.
From there, the same idea of an 80-100% diversified stock allocation makes sense.
But! This student might enjoy the fact that she owns those 7 tech stocks. Similarly, I enjoy the fact that I own Berkshire Hathaway – it’s the only non-fund investment I own, the only single stock.
If her stock ownership is important to her, I think it’s reasonable for her to keep <10% of her portfolio in those 7 stocks. The remaining >90% of her investable assets should be diversified.
Different people. Different situations. Different advice.
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