Good morning!

Every wealth journey encounters game-changing milestones that end up becoming defining moments.

The first milestone is a decision.

The decision to change everything. The decision to do whatever it takes to grow and transform, not only your lifestyle, but the very core of who you are.

Other milestones appear as that wealth accumulates. Wealth becomes easier as the journey progresses — money makes money.

Over the past couple of weeks, we’ve explored how to save your first $50,000 and what kind of doors that amount can open. Today, we’re taking the next step: how to strategically invest as you build toward that goal. I’ll walk you through the exact approach I’d follow if I were starting from scratch, including how I’d balance risk, seek out higher returns, and stay flexible when the markets inevitably throw a curveball.

Let’s dive in.

“Successful investing is about managing risk, not avoiding it.”

— Benjamin Graham 

Build $50k From Scratch — 5 Key Investment Insights

If I were to start over from zero, here are the strategies I would use to invest in a taxable account (not for retirement).

I’ll preface with the disclosure that financial advice can only be given on a one-to-one basis, because multiple factors play a role: your personal feelings toward risk, your goals for the invested money, your time horizon, your flexibility around the end date when you want to accomplish your goals, and more.

Here I show what I personally would do, given my younger age (30’s), affinity for higher risk, my goals to build wealth fast, and my willingness to adapt if markets don’t play along.

All Stock Fund 📈

I would use an all-stock fund.

Stocks, on average, have historically returned about 9%-10% annually over long periods of time (decades), depending on the timeframe measured. But it’s critical to remember: averages don’t describe the normal year-by-year market movement that we all have to experience.

Averages sound nice. They’re easy to grasp. But remember that 2008 saw a -36.81% drop in the SPY (an ETF that tracks the S&P 500 closely). The year 2013 saw upward movement of 32.31%.

Both are wildly off the mark of the average!

And remember, bear markets on average have appeared about every 4-5 years. Again, with averages, each market cycle can vary in length dramatically, some lasting more than ten years and some less than three.

So if I were saving with a 5-year goal in mind, odds are that I’d probably experience at least one year where my portfolio dropped 20% or more.

Imagine last week’s scenario: I invest about $700/month at 8% annual average return, and this goes on for 4 of the 5 years. I’m around $40,000 but then encounter a 20% drop due to a bear market that doesn’t reach its previous highs for two more years.

Bummer!

Now instead of hitting my $50,000 goal right at year 5, I have to save for about 7 more months to hit the target.

That’s why flexibility matters. 

I personally am okay to be flexible with my goal if it means I can take on added risk. But if I were not so flexible, I might choose to invest in a more moderate way, using a blend of 60% stocks and 40% bonds to help spread out the risk.

In the vast majority of historical cases, either stocks or bonds or both have been positive during a single year. So chances are my downside is not likely to be as much in any one year if invested in this more balanced way.

75% US / 25% International 🌎

The US and International stock take turns outperforming one another. And sometimes those average streaks go on for a decade or longer!

This can give the illusion that one is inherently better than the other. But that is not the case.

It’s true that the US has boosted productivity faster than Europe, and it also is generally less affected by certain geopolitical conflicts and supply chain disruptions. Remember, too, that many of the largest US companies do indeed compete globally, making them less dependent on domestic demand alone.

The US’ share of global GDP is about 12.7%, but that includes developed, emerging and third world economies altogether. For investing purposes in the short-term, I’m interested in developed economies for the most part. And among 23 developed markets, as measured by the MSCI World, the US makes up about 71%.

So I would invest about 70%-75% of my portfolio in the US, possibly favoring it a little due to its history of productivity growth and general perception of stability and strength. I’d put the other 25%-30% in a fund of international developed markets.

Because I’m discussing a taxable account, I would aim to rebalance the account no more than once per year, keeping my taxes long-term (cheaper) instead of short-term (more expensive).

Positive 3- and 5-Year Alpha 🦸‍♂️

If I wanted to aim for a higher-than-average return (of course, at the risk of underperforming), I would choose a fund that showed a positive alpha for its most recent 3- and 5-year history.

Alpha reveals whether a strategy outperformed or underperformed its passive benchmark, after adjusting for any differences in risk.

Positive alpha means the fund owners got a deal over that time period. They experienced less risk than the benchmark for the level of return they earned.

It’s important to remember that past performance is not an indicator of what will happen in the future. But it can tell us that the strategy, and the managers running the fund, succeeded previously in an important way. And that helps inspire confidence (though not proof) that they might know something others don’t that gives them a market edge.

Alternatively, they might just be getting lucky, and the fund may underperform over the next few years. That’s the risk that I have to be willing to accept if I choose to use a more active fund instead of a passive index.

Finally, I’d want to make sure the expense ratio of the fund isn’t seriously eroding the net value of the returns.

Above Average Sharpe Ratio 😎

The Sharpe Ratio reveals how many units of return I achieved in relation to the units of risk I took on.

Risk here is measured as standard deviation from the average. Standard deviation reveals how much the annual fund return deviated above or below the average return for the time period being measured (usually 3 or 5 years).

A Sharpe Ratio above the category average reveals good performance relative to its peers. For the category, the fund was a good deal over that time.

Whether that can be repeated in the future is uncertain. But knowing that it has been done in the past helps boost confidence that the strategy might have a longer-term edge over passive market returns.

Remember, the Sharpe ratio measures return compared with risk (standard deviation).

The Alpha measures the value of a manager’s active decisions to improve returns beyond its passive benchmark.

Both are highly valuable to know.

Protective Put Option 🛟

I would buy a protective put option that covered my positions, but only once I reached a significant level of investments.

If I’m investing $700/month, or $8,400/year, then in the early years my monthly savings can easily make up for big drops fairly quickly. But in later years, like when my portfolio hits $40,000, a 20% drop means almost a year’s worth of savings lost. And that’s around the time I might start hedging downside to one degree or another.

Now, unless I’m simply invested in the SPY for average returns, I may not be able to hedge all my positions completely. I might have to do an “indirect” hedge.

If I held 75% in the US and 25% International, I might simply use a partial hedge where I only buy a put option on a passive US ETF (like the SPY). If I had a much larger position in International, I might in eventually hedge some of the international side with an ETF that tracks my international benchmark (e.g. URTH for the MSCI World). Even if it’s not a one-to-one hedge, it still helps reduce downside risk.

But options are expensive, so sometimes just a partial hedge makes more sense than trying to hedge it all. I might spend 3%-4% of my total portfolio hedging my downside for the year, depending on a lot of factors like volatility, strike price, open interest (supply of options for sale) and length of the option term.

That cuts into upside return. And that makes a big difference in the long-run.

But if I’m saving for the near-term, say the next five years, then that matters less than if I were saving for 20 years or more.

I’m more interested in not losing big in the short-term than I am in squeezing every bit of upside return out of the market that I can.

So I like to keep my options at a strike price of 5%-15% below the current market value of the index. If the SPY were at $600, I would buy my put option with a strike price of anywhere from $510 (cheaper) to $570 (more expensive). And I’d push the maturity date out to as close to one year as I could get.

And I’d replace that put option at least once every six months, though once a quarter is more conservative. I wouldn’t hold it past the halfway point to maturity, because it starts to lose time value much faster.

This assumes transaction costs are negligible, which may not be the case with every broker-dealer. This strategy makes less sense if transaction costs are going to be restrictive.

Remember that 1 put option covers 100 shares of the underlying index. So if I owned 200 shares of SPY, for example, 2 put options would hedge the downside below the strike price.

Finally, keep in mind that option strategies are advanced. It’s critically important to know exactly how these work if you ever plan to use them yourself, because they can be extremely risky if handled incorrectly.

Options don’t need to be used, but I personally like them. The other way to reduce downside risk is simply to hold 30%-40% of the portfolio in high-quality government and corporate bonds.

Conclusion 🏁

Consistency in a strategy is key to success.

Of course, a bad strategy needs to be eliminated. But if you understand the “why” behind your strategy, and it aligns well with Modern Portfolio Theory (MPT), then staying consistent becomes a major contributor to your overall success.

Changing strategy based on market forecasts (aka timing the market) has been shown by the research firm DALBAR to significantly lessen returns for the average US stock investor.

So once you’ve got the time-appropriate plan in place, you can build confidently toward a fund which opens the doors of opportunity to you like never before.

And there are entrepreneurial opportunities out there that are likely to yield much higher than average stock returns. The risk is higher. The effort is greater. But they can change everything.

And that’s the importance of ascending the investment ladder from education, to savings, to investments, to eventual business ownership or a personal discretionary fund.

Pick your strategy, know your risks, and start climbing your personal investment ladder today.

Your future self will thank you.

HERE’S HOW I CAN HELP
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