There must be a way to determine how much to invest and how much to continue keeping as cash.
Markets will crash!!!
Let's look at some history of the most recent market crashes.
The MOST recent market crash was the great financial crisis in year 2008.
As shown by NBCNEWS, the decline was measured to be 56.4%
How about the NEXT most recent market crash?
That would be the dot com bubble in year 2010 and the decline was measured to be 49.1%
According to research conducted by First Trust, an investment manager, the average duration of a bear market is 1.4 years.
And since 1926, the average decline during a bear market is 41%!
Hypothetical risk tolerance assessments could mislead you
Risk tolerarance is often used to recommend how much equity levels you should have in a portfolio.
A question typical of a risk tolerance assessment for an investment recommendation is
"Hypothetically when markets come down by 50% how would you react?"
The options are:
A) Get excited and shift all my money in
B) Sell out and wait till experts indicate that the crisis is over
C) Not be bothered and invest for the long term
Which option are you leaning towards?
This is a rough scenario back in 2008
A few global companies have reported a lower performance. Even some banks are in distress.
News reported a new record low in overall share prices.
The government and international agencies forecast a lower performance for the foreseeable period.
Carefully consider it.
How difficult is it to choose option A: Get excited and shift all my money in?
How difficult is it to choose option C: Not be bothered and invest for the long term?
Do you know that anyone who has invested when the equity levels have dropped 35% would be sitting on a close to -25% themselves?
Yes, if the index peak is at 1,000 and declines reaches 650. Thats a 35% drop.
But when index declines to 500, if you had entered at 650, the feeling is close to a 25% loss!
Because 150/650 is 25%. It is NOT a mere 15% loss.
Most investors who lack experience overestimate their risk tolerance.
This could also be a problem to you.
What about option B) Sell out and wait till experts indicate that the market crash is over?
This is the choice of many in an actual market crash. At least for me, it was the most common I heard back in 2008.
It sounds logical BUT it is NOT a good decision. I'll explain more in the section below.
Hence, real experience on potential market losses matter.
How to survive a market crash
The easiest way that you can save your investments during a market crash is to find new money to invest with your monthly income.
It is where you have the capacity to go into the market and buy more equities in a market crash.
And take advantage of low prices!
Surviving in market crash is like surviving in a war.
You better dig out more ammunition especially when you are down!
The next step to knowing how comfortable losses are is to measure it clearly against your income.
Your income is what gives you REAL financial security.
I'll illustrate with an example. How does this $41,000 paper loss below feel to you?
How big is this amount as a factor to your monthly income?
If your monthly income is $10,000 this is 4months of income. Maybe this is ok.
But if your monthly income is $2,500, this $41,000 paper loss is MORE THAN 16months of income
Most become EXTREMELY uncomfortable once the investment losses are more than 18months income.
This concept was first mentioned by financial samurai.
I agree with it. It is where irrational decisions like "option B) Sell out and wait till experts indicate that the crisis is over?" come into the picture.
In a market crisis, no one know when it will be over.
Experts ONLY know it is over when everything has recovered and it is too late.
Selling out and hoping to buy later will likely create a "SELL LOW and BUY HIGH situation" for you.
Recommended formula for "Equity investment levels" based on your income + experience
In my opinion, your experience levels should really limit your risk appetite.
And we should be honest with it.
This is my recommended formula.
This formula has measured in situations with a market crash of 50% and it is designed to allow you to survive market losses.
1) Little or No investment experience: 10x your monthly income.
2) Have some investment experience: 30x your monthly income.
3) Have investment experience and been through a market crash before: 50x your monthly income. Also depends on your networth and read on market.
Put this formula against your income to find the RIGHT amount that you should be invested with.
Little or No investment experience: 10x your monthly income.
If you earn $10k/month and have little or no investment experience, it is 10x your monthly income. This makes it $100k in equities only.
Why so little? Your risk tolerance may be low because of experience.
If you have $100k in equities and a market crash happens, you could see your portfolio at a -$50,000 loss.
That would feel like 5months of your income "lost". Hopefully still bearable.
You may have a different income level and experience, so go ahead and apply what fits for you.
Also apply "Formula of how much cash to keep"
Let's take a look at Warren Buffett's Berkshire Hathaway.
This chart below shows how much cash the company has. Berkshire Hathaway's market cap has strong co-relation to the S&P 500.
For the last 20years, the amount of cash/market cap is mostly between 10%-25%.
Currently, Berkshire has about $120B and market cap is about $500B. That is about 24%
Let's you copy this formula and use it to decide how much cash you should keep.
For you, it would be cash/networth
When your net worth is $1,000,000, the amount of cash to hold is between $100,000 and $250,000.
This has 2 main implications. Let's assume back your net worth is $1,000,000
1) If you are holding more than $250,000 cash (those in the bank + fixed deposits + singapore savings bond etc), you may be under-invested. Too much is lost to inflation.
2) If you are holding less than $100,000 cash (those in the bank + fixed deposits + singapore savings bond etc), you may be over-invested. If there was a market crash, you would be out of ammunition to rescue your portfolio.
You should be filling your cash horde in anticipation of a market crash.
Do this before you start applying the 10x, 30x or 50x formula mentioned above.
3) When markets go up, sell a portion to lift the ratio into the 10% to 25% range
4) When markets come down, buy some to reduce the ratio into the 10% to 25% range
As your net worth increases from new income,
always deploy some to be invested.
This leads to the next 2 points
Point 1: should you fully sell/cash out of equities?
This is a really tricky question.
It seems logical to fully cash out of equities in a bull market like this one which is running for 10years and be pure cash at some point!
But some of the best returns are in a late stage bull market where it looks like a bubble.
These are periods of double digit returns.
Also, if you think the formula of "How much cash to keep" makes sense, then the answer
may be you DO NOT need to fully cash out of equities!
It is like trying to buy all-in at the market bottom, it puts TOO much pressure to get the timing right.
Hence, buying some and selling some to be within the 10-25% is the right way.
Point 2: Regular investing can be a solution for you
The first key benefit is that as new income comes in, a portion is saved and a portion is automatically invested.
It makes keeping the 10-25% of cash/networth easy to stick to.
The second key benefit is that if you are some distance to your right equity investment level, you are systematically getting there bit by bit.
That is why I frequently recommend having a regular investing plan.
You will reap other benefits such as dollar cost averaging which we can discuss again in a separate topic.
Last updated on February 28th, 2020 at 10:02 am