How I invest (part 1 of many)

The two most important things are:

  1. Reward.  Best measured by after-tax rate of return.
  2. Risk.  Difficult to measure.

To me, the goal of investing is to get the best balance out of risk versus reward.  The best metric for reward is rate of return- the percent at which you expect your portfolio to grow.

Simply buying stocks at “half of intrinsic value” (cigar butt investing) is not so great if it takes a long time for those stocks to reach intrinsic value.  How fast you make your money matters.  Unfortunately, it’s often really hard to predict that.

Risk

Losing money seriously hurts your returns.  If your portfolio has a small chance of going to 0, then eventually your portfolio really will go to 0.  And your expected return will be -100%.  This is known as gambler’s ruin.  In real life, everyday people sometimes run into this problem when they take on mortgages and they lose their house.

What is you lose 50% of your portfolio?  You will have to double your money just to break even.  So it is really important to avoid devastating losses in your portfolio.  Taking on too much risk will actually hurt your returns, as it is really hard to claw out of devastating losses.

Those in the professional gambling field sometimes use a mathematical formula called the Kelly Criterion (here’s a link to an online Kelly Criterion calculator).  It’s a formula to calculate how much you should bet on any given position/investment/speculation.  It gives a percentage of your portfolio that you should bet on that position to maximize your returns (the Kelly Percentage).  However, you need to provide assumptions as to your chance of (not) making money and the expected payoff.  If you are off in these assumptions, then you may be overbetting and taking on too much risk and hurting your returns.  So, a prudent strategy is to bet a half or quarter (or some fraction) of the Kelly percentage.  This has much lower risk while keeping most of the returns.  Because the future is uncertain, there is no way you can be accurate about your assumptions and I would not bet the fully Kelly percentage.

Taxes

Of course they matter!  Unfortunately, most quoted investment returns do not take taxes into account.  This completely misses the point as you are trying to grow your money after tax, not before it.

Because capital gains are taxed at 50%, I currently will probably end up in a very low tax bracket and pay very little tax.  Right now I don’t worry about taxes much (I live in Ontario Canada).  It sort of makes sense for me to churn my portfolio so that I realize gains early and pay taxes on gains now instead of the future (income smoothing).  This way, my gains are taxed while I am in a very low income tax bracket (I do not work).

I should try to avoid receiving dividends on US stocks as the withholding tax is very high.

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