#62 Establishing Your Investment Thesis – Part 2: Clarify Your Strategy - MBC REI

“The most important investment you can make is in yourself.” — Warren Buffett

Once you understand the goals for your investments [1] it is time to clarify your overall investment strategy. Building on the work of my mentors [2], I have identified five dimensions that combine to form the space of possible investments. Consider these your coordinate system for navigating the investment landscape. By determining where in this multidimensional space your optimal opportunities lie, you’ll develop a clear Investment Thesis that guides your tactical decisions.

Strategic Dimensions

As with many complex systems, there is inherent tensions between these dimensions. That is what makes this exercise challenging – but also what makes it powerful. Let’s explore these dimensions.

A) Risk Tolerance: Your Comfort Zone

There are many types of risks – too many to enumerate here. For purposes of this discussion, I will group them into two categories:

Volatility risk: This is the change in the investment value over time, while you still hold the investment. It includes cash flow variance (positive or negative) and current value variance (e.g. a stock that gets repriced daily or a commercial property where the CAP rate changes yearly).
Realized risk: This is the gain or loss that occurs when you sell the asset. This relates to the price that you get relative to what you bought the asset for.

How comfortable are you with these risks?

No-one likes losing money, but knowing how you respond emotionally and practically to both volatility and the actual loss of money is important when establishing an investment portfolio that serves you over the long term. Are you someone who immediately rebounds from any setback and just keeps steadily pushing your plan forward? Or do you lies awake at night believing that your dreams are lost whenever your portfolio valuation drops by 1%, even though you still own the asset?

Understanding both your natural risk tolerance and the overall risk profile of each investment beforehand ensures that your investments serve your psychological needs as well as your financial ones. It is important to remember that every investment inherently has risk. Even “risk-free” T-bills bears risk: you might have to sell for a loss before it matures (if interest rates rise) or that inflation could be higher than expected reducing your purchasing power over the hold period. There are ways that you can reduce the level of risk involved in a decision, but only to a point.

For most of us, risk tolerance varies across different aspects of our life. Someone may be completely comfortable mountain climbing or sky diving, but still worry about their retirement income. Thinking about how your perspective varies gives you insight into how much financial risk you want to take.

Consider the following questions:

How did I respond during the last stock market crash? Even if you weren’t heavily invested in the market, how you responded to the news and what actions, if any, you took can be insightful.
Realistically, what would happen if you lost your entire investment in a deal? There is a big difference between having to work for an extra 3 months and suddenly becoming homeless. Putting the risk in context helps you assess what level of risk you are willing to accept.
How would investment failures impact others in your life? When your decisions directly affect your partner’s retirement plans or your children’s education fund, their responses become relevant factors in your decision-making.

B) Investment Timeline: Your Time Horizon

To effectively establish your Investment Thesis, you must consider when you need to access your investments. When we discussed setting financial goals, the proposal was to look 10 years out but timelines for specific investments may be different.

Consider James, who is going to be retired in 10 years and thus needs access to certain investments before then. Kay, on the other hand, is just starting to build up her retirement plan and has a 30+ year horizon before needing those funds.

Realistically, most people manage multiple time horizons simultaneously. There is planning for retirement, which starts out far in the future and gets closer each year. There are also shorter term goals like Ron’s goal of paying off his house and buying a rental property or Kay’s plan to fund a brokerage account.

Understanding your timeline before needing the invested capital helps determine which tactics align with your Investment Thesis.

While many people will claim to be long-term investors, few hold on to a single investment for 10, 20, or more years. There are a lot of great reasons for this, including:

Your reason for originally investing in something is no longer valid. For example, if you bought a property in an emerging tech hub and now the neighborhood has matured, it may be time to move on.
A better opportunity emerges. For example, if you have owned a property for 5 years, completed your renovations, and now have significant equity in it, you might sell to harvest that equity and put it all to work in a new investment.
Fundamental market shifts occur. For example, changes in market demographics, macroeconomics, or tax laws may drive a portfolio adjustment.
Relationship dynamics change. Investments are ultimately about relationships, and not all relationships last forever. At some point, it may be best to move on.

With this in mind, determine how long you want each investment to last before you invest. If you are trying to maximize the velocity of your money, to build wealth faster, shorter investment timelines allow faster compounding. However, if you are prioritizing reliable returns with minimal overhead, constantly reinvesting the money is likely not your best option.

C) Cash Flow: Your Operational Requirements

When investing, you receive returns in two primary ways. Most obviously, you get money back when selling an asset at a profit—appreciation-based returns. Many assets also generate cash flow while you hold them, such as rental income from properties or dividends from stocks.

While some assets provide both appreciation and cash flow, one approach usually dominates. For example:

a note or mortgage is cash-flow centric. There is no appreciation in your original investment, just a regular stream of income until the loan is paid off.
a development project is appreciation focused. There is no cash flow until the project is completed and sold off, all of the money collected during the project is used to pay for the development.

The differentiation is not always consistent across an asset class. A single family rental property in California will likely provide negative cash flow, but appreciate significantly over time. A rental property in the Midwest may generate moderate cash flow within the first year, but is unlikely to significantly appreciate over time, roughly tracking inflation.

As part of your Investment Thesis, determine how important ongoing cash flow is to meeting your financial objectives, particularly if you’re working toward replacing your paycheck with passive income

D) Active Involvement: Your Time Commitment

Everyone faces time constraints. There isn’t enough time to do everything that you want to do. Yet making informed investments requires time. Some commitment is necessary for every investment, no matter how “passive.” Moreover, the more time you invest, the greater your potential returns, as you’re compensated for both your sweat equity and financial capital.

The amount of time that you are willing to invest defines what investment options are open to you. At minimum, you need to educate yourself about finance and understand your investments. Even purchasing index funds or individual stocks requires basic education and research for success.

Investing in real estate requires more time. Even relatively passive investments like syndications require thorough due diligence on both the sponsor and the deal before writing a check. Purchase own real estate directly creates a business – even if you employ a property manager and have minimal renovation plans.

As part of defining your Investment Thesis, you need to determine exactly how much of your time you are willing to commit to managing your investments over a multi-year period of time. Once you make an investment, there can be a significant cost to undoing it, so you need to be comfortable with your decision.

E) Required Returns: Your Growth Targets

Finally, and least importantly, understand what returns your portfolio needs to generate in order to meet your goals. Typically, less risky investments will have a lower rate of return and more risky investments will have a higher rate of return. However, that generality is not an absolute. If you increase your education, put in more effort, or look at alternative asset classes, you may be able to generate larger returns without significant additional risk – within limits. Ultimately, if you are unable to obtain your desired returns within your risk tolerance, you will need to revisit other options such as saving more in order to accomplish your goals.

Since returns are never guaranteed, projections acts as only as a yardstick to compare perceived risk / return tradeoffs across different investment opportunities. Your strategy should never require that all of your investments perform at the promoted rate of return for you to meet your goals. These projections are notoriously unreliable and investments almost never perform exactly as expected over time.

Developing a Cohesive Strategy

Everyone wants a low-risk, fully passive, long-term investment that is fully liquid and has great returns. Unfortunately, such investments don’t exist. In the real world, trade-offs constrain the space of possible investments. Within these constraints, each investor needs to choose their target areas.

For most people, there no single investment strategy suffices. Your portfolio likely needs to be an allocation across multiple strategies:

Short term investment strategies to accomplish near-term goals. Long-term strategies for retirement and long-term wealth building
Conservative strategies to build the foundational wealth you need to meet your goals. Calculated risks to enable bigger dreams.
Cash flow to fund new investments and address liquidity issues. Appreciation to generate larger returns and grow wealth faster.
Active engagement for investments you are personally passionate about. Passive investments for assets that you do not want to manage directly.

Let’s revisit our three subjects from [1], to see how they develop their own strategies.

Similar to most entrepreneurs, Ron is comfortable with risk. He believes that by working hard and putting in the time and effort to build his business, over the long term he eliminates most of the financial risk involved in real estate development. His initial focus is on short-term wealth growth to develop enough of a nest egg to allow him to leave his job within 3 years. The profits from doing flips with his friends will be reinvested directly into his business while using his job to pay for his living expenses. Thus, he is focused on maximizing return for his effort not on cash flow. Since he is relying on others to fund the flips, while he contributes his time and knowledge, his financial return is infinite ($0 down). His current strategy is high-risk, short-timeline and active. Once his business is established, he will transition into a longer term strategy of building equity in his home and a rental portfolio.

Kay is less comfortable with risk. Although she is young enough to weather volatility she is afraid of realizing significant losses to her portfolio. As a result, she is not willing to invest more than $50k in any specific investment. Her job to funds her current lifestyle and pays down her student loans, so cash flow is not important to her. Her job requires the majority of her time and energy, so she is looking for passive investments where she does not have to regularly invest effort. Focusing primarily on her retirement gives her a long-term perspective for the majority of her portfolio, while she is allocating 25% of her investments to buying her first home within 2 years. As a result, her current strategy is targeting a 9-10% passive return with moderate risk, and mix of 25% short term and 75% long term investments.

As James is getting close to retirement, he is very conservative with his investments and focused on preserving capital while still growing his nest egg. He is prioritizing cash flowing investments since he will be losing his paycheck soon. Given his current job and plans to travel when retired, he is looking for passive investments that will not demand much of his time in the future. He is targeting 7-8% cash on cash returns with the plan to reinvest the cash flow until retirement. Once he hits his target net worth, he can become even more conservative while still sustaining his lifestyle or he can expand his lifestyle. Since his investments will fund all expenses, he is planning to have 10% of his investments in highly liquid assets so that he can easily make up any short-term cash flow issues.

Clarifying Your Strategy Summary

By understanding where you stand on each of these five dimensions—risk tolerance, timeline, cash flow needs, active involvement, and required returns—you are well on your way to developing a clear Investment Thesis that guides your decisions. This isn’t a one-time exercise; as your life circumstances evolve, so too will your position along these dimensions.

The goal isn’t to find a perfect investment that optimizes all dimensions simultaneously—such an investment doesn’t exist. Instead, aim to build a portfolio that reflects your unique circumstances and aspirations while honoring the abundance mindset that underpins true financial freedom.

Next, we’ll explore how to define the tactics that you will use to implement your strategy and accomplish your goals.

For additional reading:

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.