How Much Should I Invest?

Before talking to your first investment prospect, evaluate your personal financial situation and set guidelines for the types of investments that will help you meet your needs and goals, and honor your values, while staying within your tolerance for risk. Financial advisors can be very helpful with this process, but you can also do it on your own. Begin by looking at your big picture situation: How old are you, and how much risk are you comfortable taking? What’s your cost of living, and how much income do you need from your investments? How much cash do you need on hand for emergencies and large upcoming purchases? With these things in mind, you can start creating investing rules that will guide the types of investments that will be the best fit for you and achieving your financial goals. Consider writing down your rules for some or all of the following criteria, as you see fit:

1. Diversification, also known as “Don’t put all your eggs in one basket,” means selecting a wide variety of investments for your portfolio in order to minimize the harm that any one bad investment, or category of investment, can cause to your overall financial situation. You should diversify in many ways, not just one. For example, you should diversify across asset classes (stocks, bonds/loans, real estate; this is called your asset allocation), across industries (retail, manufacturing, food, technology), geographically (local, domestic, international), and any other ways that feel right to you. Most importantly, you should specify in advance the maximum amount you are willing to put into any one investment. Your diversification rule could say something like “My asset allocation should be 40% stocks, 40% bonds, and 20% real estate (give or take 10% each). I can invest up to 20% in any one industry. I will invest 20% locally, 50% domestically, and 30% internationally (within 10%). I will invest no more than 5% of my money in any single deal.” Once you’ve decided on this investing rule, you’ll know how much money you can sensibly put into local investments. For more on determining your diversification rule, see the next item.
2. Risk tolerance is your ability to remain comfortable in the face of actually or potentially losing money. It is closely related to diversification, because diversification lowers risk and can therefore make riskier investments more acceptable as a smaller portion of your overall portfolio. For example, a conservative investor could reasonably invest in a very risky investment by putting less than 1% of his money in; a more risk-tolerant investor could be comfortable putting more in. Investors with greater total assets can generally afford to be more tolerant of risk. You should know the differences between riskier investments such as stocks and ownership in private companies, and more conservative investments such as bonds and loans. You should also be able to distinguish conceptually between safe and risky loans, which depend on the borrower’s ability to pay you back. For example, a US treasury bond is generally considered safe because the government has never failed to pay anyone back, whereas loaning money to a local startup without collateral would be considered risky. The due diligence process is designed to reveal the various types of risk in an investment, so ideally, during the process, you should get a clear sense of whether or not you are willing to take those risks with any given investment. The bottom line is that your diversification investing rule should be in line with your perceived risk tolerance. For example, if you are less tolerant of risk, your diversification rule should require more bonds and loans, less stocks/equities, and a lower maximum amount in any single investment; and vice versa.
3. Liquidity is how quickly and easily you can access cash, including by selling investments or borrowing. You need cash to cover both expected and unexpected (emergency) expenses, so it’s important to have sufficient liquidity to meet your needs, both now and in the future. Local investments tend to be illiquid; local businesses typically cannot repay loans ahead of schedule since they spend your investment money to buy things, refinance loans, hire people, etc., and have to generate cash flow to pay you back over time. In the meantime, you’ll need other sources of liquidity, such as bank accounts, money market funds, publicly traded stocks, and mutual funds. Ideally, your sources of liquidity should be diversified as well, so trouble in one part of your portfolio won’t make it difficult to raise cash when you need it. Your liquidity rule could be “I will keep six months’ worth of expenses in cash at my local bank, and at least 30% of my portfolio will be in stocks or mutual funds I can sell at any time.”
4. Time horizon is how long you expect to own an investment before it is sold or paid back. You should choose investments with time horizons that match up with your future needs for liquidity and income. For liquid investments, the time horizon can be quite flexible. If you buy a publicly traded stock, for example, you can probably sell it a day later or 20 years later. Illiquid local investments are less flexible in their time horizons, but may be longer or shorter than you initially expect. For example, if you make a loan to a local small business, the agreement may be for them to pay you back in two years. That investment would have an expected two year time horizon; however, the agreement could allow for you to be paid back early without penalty, resulting in a shorter horizon, or the business could run into trouble and not be able to pay you back on time, giving you a longer time horizon. Be sure to understand what the time horizon of a given investment is, how it can vary unexpectedly, and how the time horizons of all your investments should work together to meet your financial needs. Your time horizon investing rule could be “I can lend up to 60% of my local investment allocation for 5 to 10 years, and the rest should have a time horizon of 2 to 3 years.”
5. Returns are how much you expect to earn on your investments. “Gross returns” are how much an investment or portfolio earns, beyond what you put in. “Net returns” are how much of the gross returns you keep after you pay all fees and taxes related to your investments. If you require a certain level of returns in order to meet your future needs and goals (the financial planning process can help you determine that), then make sure that your portfolio, taken as a whole, is expected to generate those net returns over time, while staying diversified, liquid enough, and within your tolerance for risk. The challenge with returns is that the expected future return for an investment is almost always a matter of probability rather than certainty. For a local loan, for example, you may be expecting to receive 8% in interest, but if there is a small chance that the business will fail, then your expected return, taking into account the possibility of a loss, is lower than 8%. Your returns rule could be “I need to make 4% returns per year on my local investments, after taking into account potential losses, taxes, and fees.”
6. Taxes are assessed every year on interest, dividends, and realized gains from investments that you hold in your own name. These investments are considered “taxable.” Investments held in IRAs are not taxed on their income or gains every year; however, you will pay income tax on money that you withdraw from a Traditional IRA. Roth IRAs are never taxed on gains or withdrawals, but you do pay tax on income that you put into them. Generally, you cannot withdraw money from IRAs before age 59½ without significant penalties, so that naturally creates a longer-term time horizon for IRA money, especially for younger people. You can use your IRA to invest locally, but relatively few IRA custodians offer the specialized product known as the Self-Directed IRA (SDIRA) that makes it possible. SDIRA custodians are easy to find online, but fees and services vary widely. SDIRAs are more expensive than regular IRAs, and require more paperwork, but they allow you to purchase promissory notes, ownership shares in private businesses, and other non-publicly traded forms of local investments for your IRA, not to mention other “unconventional” investments such as real estate. Be aware that SDIRA fees offset your returns, so for smaller investments, the fees can actually exceed the returns, turning a profitable investment into a loser. Therefore, it usually makes sense to invest relatively larger amounts through SDIRAs. Overall, it is important to understand how your investments will be taxed, or not, and to make sure that your tax strategy (and any fees associated with it) fits with your net return goals. Your tax rule could be “I can invest up to 10% of my taxable portfolio in local investments, and up to 20% of my IRA through a Self-Directed IRA.”
7. Many people choose to make investments that are in alignment with their personal values, whether those are religious, social, or environmental, and avoid investing in companies that are working against, or are incompatible with, the values they believe in. This type of investing was historically called Socially Responsible Investing (SRI), and more recently has been termed Sustainable, Responsible, and Impact (SRI) investing. Impact investing refers to investments that are intended to have some kind of positive, measurable effect, or impact, on something, such as job creation or community development. Most local investments are considered impact investments, because they can enable a local small business to hire people, open a store, add to the local economy through purchases of local goods and services, and generally create real tangible change in a community. On the other hand, purchasing a publicly traded stock or mutual fund will hardly ever have measurable real-world impact, unless you or the fund uses shareholder advocacy effectively. You should consider if specific values and/or impact are important to you, and if so, create a “values & impact” investing rule to guide your investment selection process. An example could be “I will invest in impact investments as much as possible, especially focusing on renewable energy and sustainable agriculture, and I will avoid investments in industries that cause pollution.”
8. Locality is where the impact of an investment is most felt. Locality matters in local investing, so you should consider defining what “local” means to you. Begin with a geographic area that feels local. Ask yourself what parts of a business, such as ownership, staff, office location, and so forth, need to be located in the area for you to consider it a local investment. For example, is an investment “local” if the employees and physical location are nearby, but it is owned by someone outside the area? 100% local small businesses are straightforward – they are either in your area or out of it. Chain stores, franchises, and non-locally owned businesses are not as clear. What matters to you in your local investments? Who benefits? Your answers can help you construct a locality investing rule.
9. Control is how much power you have to affect decisions that are made at the business you’ve invested in. Examples of control could include having a seat on the board of directors, having a majority of voting shares, or having the ability to approve or disapprove specific major business decisions such as borrowing money. With publicly traded stocks, most people have virtually no control. With local investments, more control can be negotiated for and written into the agreement, especially when investing larger amounts of money relative to the size of the business. Sometimes, large investors can have more at stake in the business than the managers themselves, so control is viewed as a way to protect and enhance the value of a significant investment. Still, it’s rare to have control in local investments.
10. Leverage is how much you are borrowing relative to how much you own. It’s common to have a leveraged home in the form of a mortgage. Some people borrow money on margin in their brokerage accounts and use it to buy stocks, which is much riskier than buying stocks with cash. The more debt you take on, the higher the risk that you could experience a cash flow crunch that prevents you from being able to make your interest payments, which could lead to forced sales of your assets or even bankruptcy. Always be aware of how much you are borrowing and keep it within your tolerance for risk. It is not recommended to borrow money in order to invest it locally.