How to Invest Your Money: Understand When to Take More or Less Risks

Congratulations! You found a career path that brings about the number one rich person problem – where the hell do you invest all the cash you make from your high-end salary and bonuses? This is one of the biggest problems that fortunate guys have in their 20s or 30s nowadays.

First off, before I begin… realize how absurd this problem is relative to the real problems that millions of other have in this world. Make sure you sit down for a second, appreciate the situation you are in today and say thank you to those that have helped you along the way.

So, let’s begin. Here is the situation that you and countless of others are probably in:

• Landed a good, high paying finance job out of college or made a ton of money doing something different
• Paid off all your student loans
• Maxed out your 401K
• Managed to get promoted or move to an even higher paying job
• Have a good chuck of savings sitting in your bank account in cash

Before you have time to think about it (since you have thus far slaved away your life), you are sitting on hundreds of thousands of dollars and have absolutely no idea what to do with it. Hopefully it was worth it.

Maybe my views will change when I get older, but my philosophy around work is to work hard while your young so you can have more free time and enjoy spending time your kids / wife when you get older.

Here I am going to teach you the basics on different types of securities that you can invest in without worrying about losing your money in a market crash or a recession. I am not going to tell you exactly what you should be investing in and when, but will provide a basic framework so you understand how to gauge where we are in the cycle and the right times to take on more risk.

Disclaimer: I am in no way, shape or form a financial advisor. Any piece of advice you learn in this article is my own opinion and can change at any time. In other words, make your own decisions.

Before I get into it…

The number one worst piece of advice EVER is to just put all your money in the stock market if you are young because the market always goes up over the long run.

Okay fine, maybe not the worst piece of advice, but there are better ways to manage your money than to put 100% of it in the stock market.

Yes, if you are young then max out your 401K and put that money in the lowest cost fund that tracks the S&P 500. But for the cash savings you have on hand, you need to have a more thoughtful strategy. Putting it all in the market is just not the smartest investment decision.

A few of the points made below sound pretty obvious. But, at the end of the day your philosophy around investing should always be based on the opposite of what others are doing. In other words…

“Be fearful when others are greedy and greedy when others are fearful.”

Warren Buffett

The first step is to understand where we are in the economic cycle. Then once we know what stage of the cycle we are in, then we can figure out what the best investment opportunities are.

Some people will argue that figuring out where we are in the cycle is a fools game because you are essentially trying to time the market. That is not what we are trying to accomplish here. We are trying to get the odds on your side by knowing which phase of the cycle we are in. This is why Warren Buffett’s Berkshire Hathaway sits on over $100Bn of cash. He is just waiting for the cycle to turn to invest it all!

Understand where we are in the cycle   

Before figuring out where to invest your extra cash, you need to understand where we are in the economic cycle. Essentially, you want to increase risk when we are at the beginning of a cycle and decrease risk when at the end. Pinpointing exactly where we are is obviously impossible, but there are signs that allow us to determine how close we are to the beginning or how close we are to the end of a cycle. 

Beginning cycle dynamics

1. Higher than average unemployment rates

Unemployment rates spike to high levels during the beginning of an economic cycle. Below you can see historical unemployment rates in the US since the late 1940s:

As you can see, unemployment rates increase significantly during a recession, which marks the end of the last cycle and the beginning of a new one.

2. Profit margins near historical lows

Profits drive earnings, which ultimately drives a company’s stock and multiples. Companies in the US have experienced a massive tailwind to their profit margins since the early 1950s, from globalization, to enhanced productivity per unit of labor, to declines in tax / interest rates. Thus far, profit margins have generally risen over the long run due to these factors. If any one of these factors reverse, companies are due for a serious earnings correction.

Below you can see historical operating profit margins of the S&P 500 and where we are today. The early parts of the cycle are when profit margins are below historical levels.

3. Federal reserve significantly cuts the fed funds rate to zero or below zero

Almost every recession in the past has started when the yield curve steepens. This happens when the fed cuts interest rates (ie. short term rates go down, increasing the spread between short and long dated treasuries).

The fed typically cuts rates to increase stimulus and allow companies / people to increase leverage using cheap financing. This happens when growth is slowing.

Now the beginning of the cycle does not start when the fed just begins to cut rates. It happens when the fed has had to significantly cut rates.

4. Valuation metrics are below historical norms

Now I am not talking about using a simple price to earnings ratio. This metric can be skewed by a number of factors like historically lower than average interest rates, tax rates, commodities, etc.

My preferred metric of valuation for the cycle is based on market capitalization as a percent of total GDP, also known as the Buffett Indicator because it is an index Warren Buffett has historically preferred.

When stocks drop 40%+, it is usually a good signal to start increasing risk as this implies valuations levels have significantly declined.

Below is the Wilshire 5000 Market Cap. Index / GDP. When this indicator is below historical averages, that usually signals a good time to buy.

5. High levels of risk aversion

Now this is not a metric you can easily track, but you can gauge based on the general market / news sentiment. Risk aversion generally increases when unemployment is high and job creation is low.

Generally, you can look at headlines on CNBC / Barron’s to gauge where the general sentiment is at. You can also look at the amount of money that PE / HF / VC firms are raising.

End of cycle dynamics

1. Increasing levels of wage inflation

When the economy has been doing really well, jobs are created, unemployment rates drop and more and more people come back into the labor force. Once the economy reaches full capacity (meaning there are not more people available to come back into the labor force), then wage inflation starts to pick up. Essentially, companies need to pay people more money to keep them or else they will move to another firm that pays more.

The end of the cycle occurs when wage inflation starts to pick up significantly. See below for historical wage inflation rates to gauge where we are in the cycle.

2. Profit margins near all-time highs

The opposite of what we discussed above. End of cycle occurs when profit margins have expanded significantly to the point where they can no longer expand.

3. High levels of consumer driven speculation

Risk tolerance increases significantly when there is a high degree of consumer optimism. People feel secure, forget about the hard times in the past and tend to engage in speculative behavior.

There is not any individual metric that we can track to gauge the levels of consumer speculation. However, we can look at three specific instances in the recent past to get a sense of how and when this behavior manifests.  

• Tech bubble in the late 1990s and early 2000s when there was a massive level of speculation in technology stocks and companies that had negative profit margins and cash flows
• Housing bubble in 2006/2007 where a lack of regulation and lending requirements led to a mania in housing prices and home ownership
• Cryptocurrency bubble in 2017/2018 where massive levels of speculation occurred on worthless digital “currencies”  
• US stock market bubble of 2018/2019 where low interest rates have driven investors to search for high levels of returns in equities and “zombie” companies that do not produce any profits (ie. Tesla, Beyond Meat, Uber, Lyft, Snapchat, Tilray, etc.)

4. Federal reserve begins to cut interest rates

The Fed cuts rates to stimulate growth in response to a slowdown in the macro picture. Initially, the market jumps for joy when the fed signals that they may begin to start cutting interest rates. Historically, however, this does not last long and is a great late cycle indicator.

As you can see in the chart below, the yield curve usually begins to steepen right before a recession. The steepening is caused by the Fed cutting short term interest rates, increasing the spread between short and longer dated treasuries.

Where do you invest now that we know approximately where we are in the cycle?

As you can see above, it seems more likely than not that we are extremely close to the end of the cycle. While nobody can tell you precisely when the next recession will hit, it seems that we are currently in the later innings (around the 8^th, potentially 9^th inning) of the current cycle.

The question you need to ask yourself is how much risk are you willing to take on? Think of this decision on a scale:

• On one end of the spectrum you can be 100% invested in equities and take on debt to buy other types of investments (most risky)
• On the other end you can be 100% invested in cash / short term treasury bonds (least risky).

Potential investment opportunities at different levels of risk

I have categorized various investment opportunities into different risk buckets. Depending on your view of where we are in the cycle, you want to take on more risk when the economy is in the early parts of the cycle and take on less risk when the economy is near the end.  

Below are the main options on where to invest you can potentially invest your extra cash:

Very Low Risk

• Cash / money market funds (1-3% annual returns) – do not EVER have a large amount of cash sitting in your bank checking or savings account. You literally make close to nothing by doing this. I typically keep <$2,500 in my checking account and nothing in my savings. Move your cash to an online brokerage (Fidelity, ETrade, Charles Schwab, etc.) and put it in a money market fund.
• Short term treasuries (1-3% annual returns) – if you have an investment account on Fidelity, ETrade, Charles Schwab, etc. then you can directly buy short-term dated treasuries for free. Do not buy anything more than a year unless you are okay having your money locked up for that amount of time. The good thing about directly buying treasury bonds is that in some states the dividends are tax free.

Low Risk

• Short-term Treasury ETFs (2% returns + potential increase in value) – SHY is the iShares 1-3 year bond fund, which means it is a short term fund that invests primarily in treasury bonds. The benefit of buying an ETF instead of directly purchasing the bonds is that you can sell the ETF whenever you need to if you ever need to use the cash.
• If you think the economy is slowing and the fed needs to cut rates, then the value of this ETF will go up (bond prices move inversely with interest rates). The price of the ETF can move depending on where interest rates are heading, but historically it has not moved more than 5%, so not that volatile.  

Medium Risk

• Gold – The easiest way to invest in gold is to buy GLD, which is the SPDR Gold Trust ETF. My philosophy is that you should always have 5-10% of your net worth in gold. It is a good inflation hedge and also a way to protect yourself from a potential devaluation of the dollar or your country’s respective currency. Most of the major economies (including the US) are financing all their expenditures by taking on massive amounts of debt, which is definitely not sustainable over the long run. Gold will protect you if this ever becomes unsustainable.
• Longer duration treasuries (3%+ returns) – TLT is the iShares 20+ year treasury bond ETF. By buying longer duration treasuries, you are essentially clipping 3%+ dividends each year and potentially making more money in the price appreciation of the investment. Be careful here though as the price can fluctuate to a great degree depending on where interest rates are going. If you think interest rates need to go down, then you buy TLT and make a good amount of money if you are right.

High Risk

• REITs / Utilities (VNQ or XLU ETFs) – These sectors provide a healthy dividend, which provides a good 3%+ annual income stream. If you think interest rates are going lower, then you should be buying these securities. The ETFs invest in equities so if there was a recession or a market crash, then these will obviously go down.
• Technology / Consumer Cyclicals (XLK or XLY ETFs) – These sectors are good early cycle investments and a way to bet on a growing economy.
• Levering up to purchase tangible assets – If you are thinking about buying real estate or a small business using 50%+ debt, then you want to wait until we are in the early stages of a cycle. This will allow you to take on very cheap debt (given the fed will have cut rates to zero in the early part of a cycle) and buy assets when they are generating income below their historical profit levels (so you can keep all the upside when profits return to normal levels). Read the Top 10 Reasons to Buy an Apartment in NYC to learn more about purchasing real estate.
• Investing in your fund (for those who work in private equity / HF)– before you think about putting your money in the fund that you work for, make sure you understand that you are placing all your eggs in one basket. If your firm does not do well, you do not get paid good bonuses and your investment will have lost money. You are essentially making a levered bet on the market. Now if you have confidence in your firm because it has decades of experience and good returns throughout different cycles, then disregard what I am saying (although you are less likely to lose money if you invest earlier in the cycle).