The perfect portfolio: How to balance the 3 motivations of investing

What’s your motivation when it comes to investing?

This is a trick question.

Most financial planning misses this point, but nobody has just one motivation when it comes to investing. In fact, you’re likely to have three:

• Protect lifestyle (avoid becoming poorer, and the fear of getting poorer)
• Maintain lifestyle (even after retirement)
• Improve lifestyle (relative to where you are now, and relative to other people)

In other words…would you like to improve your lifestyle? Sure! But would you be willing to go all-out for Improvement even if it came with a significant risk of going broke? Probably not.

On the other hand, would you like to maintain your current lifestyle while taking it a bit easier? Of course you would. But to achieve that, would you give up any prospect of significantly improving your life from where it is now? Again, probably not (I’m sure you know someone who lives very cautiously but still sometimes buys lottery tickets).

It’s a balance: every investor has at least some of each motivation, but they’ll assign a different level of importance to each.

Each asset you buy is suited to serving one – and only one – of these motivations.

The logical consequence of this?

You can only decide what assets to invest in once you’ve decided on which motivations you want to serve and in what proportions.

Let’s take each in turn:

Motivation #1: Protect your lifestyle

You don’t want to end up having to drastically cut back if you lose your job, if you get ill, or if the economy takes an unprecedented dive. In short, you don’t want your financial life to be fragile: you want to put a bit of bubble wrap around it, so you can take some knocks throughout the journey.

Nobody wants to be worse off, regardless of their starting point. For one person, a setback might mean a risk of ending up on a friend’s sofa – for another, it might mean yanking the kids out of private school. One is objectively worse than the other, but both are psychologically painful: everyone wants to avoid their lifestyle getting worse, even if they’re starting from a privileged point.

This motivation is all about safety, and downside protection. You’re not expecting the assets you select to address this motivation to rise in value: you just want them to be available to you if you need them, regardless of what’s going on in the wider economy.

Assets in this bucket would include:

• Cash (in the form of an emergency fund)
• Gold
• Insurance policies
• Premium bonds
• Annuities
• Your own home

Motivation #2: Maintain your lifestyle

On top of avoiding disaster, we’d all like to be able to achieve the same lifestyle we have now while taking it a bit easier – whether that’s earning some “passive income” so we can cut back on working hours without reducing spending, or building up assets for the future so we can still enjoy our current lifestyle after we’ve stopped working completely.

Investments suited to serving this motivation are those that – on average – grow by a respectable amount more than inflation every year.

These could include:

• Broadly diversified stock market investments
• Investment-grade corporate and government bonds
• Property bought for its ability to produce rental income

These investments involve taking on more risk than those geared for Protection (the stock market might crash, for example), but over a long enough time period you’d expect them to make you a bit better off every year. They won’t see you suddenly become the richest person in the world, but they’ll help to maintain your position relative to everyone else, even when you retire or take a step back from work.

These two motivations combined – protection and maintenance – are what traditional investment portfolios are built around. The idea is that you insulate yourself against disaster and get a bit better off every year, so at some point you can start living off your investment income rather than your earned income.

These are worthy aims, and I can’t imagine anyone who wouldn’t want to achieve both. But there’s a third motivation that typical advice tends to ignore…

Motivation #3: Improve your lifestyle

Let’s be honest: there’s at least part of you that would like to be significantly better off. 

You wouldn’t just maintain your lifestyle: you’d be able to move to a bigger house in a nicer area, take more holidays, buy fancier stuff…and just as importantly (admit it), you’d now be wealthier relative to your friends and acquaintances.

Traditional investment models tend to pretend this motivation doesn’t exist, because achieving it involves taking outsized risks and putting in outsized effort. As such, it’s difficult to give one-size-fits-all advice – all reassuringly back-tested to show how that strategy would have performed over different periods in the past.

Assets in this bucket might include:

• A large concentration of stock in a single company (including your own)
• A large concentration of stock in a single risky sector
• Angel investments or venture capital
• Leveraged property investment, geared for growth
• Speculative property investments, like short-term “flips” or immature overseas markets

These are assets that can go very right or very wrong. Some will do both: they’ll have a couple of dreadful years followed by an incredible one. That’s why you can’t rely on these investments to protect you: you need to know what you signed up for, and be willing to deal with some swings in your fortunes before your financial position is eventually improved.

It’s understandable that this motivation is ignored, but it’s a problem – because the psychological need for improvement isn’t being met. As a result, people will nod along politely as their financial adviser talks about the benefits of a diversified portfolio that grows slightly above inflation for a long period of time… then go out and buy a house to flip for a quick profit.

How should you weigh each motivation?

The most important asset allocation decision to make is how important each of these motivations is.

If you get the size of each of these “buckets” of investments right, the exact composition of investments that goes within them doesn’t matter so much.

(I wrote about how to decide what to invest in here.)

Deciding on the relative importance of each motivation is completely personal to you, and it’s a psychological more than a numerical exercise.

Here are some of the points that will play into your decision:

Where you’re starting from

The wealthier you are, the more risks you can afford to take. For example, a billionaire could easily have 80% of their assets in the risky “Improve” category. Why? Because 20% of a billion – £200 million – invested in safer investments would easily be enough to keep them (and their yachts) afloat if everything else went wrong.

That doesn’t mean all billionaires should take this kind of risk: as I said earlier, becoming relatively worse off is painful even if you’re still richer than 99% of other people. The point is that the more you’re starting with, the more risks you can take if you want to.

Your fear of loss versus desire for gain

Think about how much your total assets are worth (or take a guess). Now imagine I offer you a bet where there’s some percentage chance of me doubling it, and some percentage chance of me taking half away.

What percentage chance of a big loss would be acceptable for you to accept the chance of a big gain? 1%? 10% Coin-flip?

Everyone’s answer will be different. Some of that is – again – because of where you’re starting from, but a lot is pure psychology.

You can be a risk-taking billionaire or a fearful one. A risk-taking penniless student or a fearful one. There’s no right or wrong: it’s just a result of how you’re wired and the life experiences you’ve had. But it’s worth knowing, because it’ll cause you no end of stress if you adopt an approach to investing that’s not aligned with your risk tolerance.

How old you are

Having 20% of your portfolio value wiped out by some misfortune when you’re 25 years old is no fun… but at 65 years old when you’re about to retire, it could be disastrous.

That’s why the typical investing advice is to gradually shift the balance of your portfolio away from risk as you get older. This is sensible advice, but there’s more to it…

Your earning potential

The normal age-related advice is derived partially from how long you have to recover from a setback, but also your earning potential: a 20-year-old is likely to generate more future earnings over the rest of their working life (some of which can be invested) than a 60-year-old.

Earning potential goes further than age, though. Say you’re a newly qualified lawyer in your early twenties, with millions of pounds in future earning potential. You’ve got a lot of options – including being very aggressive if you want to, because if you suddenly lost everything aged 40 you’d still expect to earn millions more in the future which you could save.

Compare this to someone of the same age with no particular qualifications or experience. Realistically they just can’t take on as much risk, because they have a limited ability to earn their way back from a setback. Another way of looking at this is to consider your earning potential to be an asset, and put it in the Protect category – meaning you can put more of your financial assets into the other two categories.

Summing it up

To recap:

1. Everyone has 3 motivations when it comes to investing
2. Each person will put a different “weight” on each motivation depending on various factors
3. Every asset you can invest in is suited to addressing one, and only one, of the motivations
4. So the most important decision to make when building an investment portfolio is to get your motivations straight – then everything else falls into place.