Hello, everybody. It's Sam from Financial Samurai. And in this episode, I'm going to introduce a new concept called Financial SEER, S-E-E-R. It stands for Financial Samurai Equity Exposure Rule. And it's a way to quantify risk tolerance and determine appropriate equity exposure. So after the fourth quarter of 2018, where we saw basically a hammering of the stock market, I thought it was a good idea to figure out and to help listeners figure out what is the appropriate amount of exposure one should have to equities.

I've been trying to build meaningful wealth in a risk-appropriate manner ever since I graduated from college. And that's what I want all you guys to experience as well. I started my career soon after the 1997 Asian financial crisis. And that was an interesting one because currencies, from Thailand to Indonesia, they devalued tremendously overnight, causing many international college students to just drop out.

And I had a couple of those. I was like, whoa, what's going on? So I fully appreciate how hazardous the road to building great wealth can be. And I think most investors overestimate the risk tolerance, especially investors who've only been investing with a significant amount of capital since 2009.

We've just seen a phenomenal nine-year-plus run bull market. And sequence of risk is pretty real. Once the losses started piling up, it's not only the melancholy of losing money that starts getting to you. It's the growing fear that your job might also be at risk. Some of you might erroneously think the richer you get, the higher your risk tolerance.

After all, the more money you have, the bigger your buffer. This is a fallacy because the more money you have, the larger your potential absolute loss. For most rational people, their lifestyles don't inflate commensurately with their wealth. They still remember what it's like to be frugal and to save money.

This is why even rich people can't resist a free rubber chicken lunch. Further, there will come a time, hopefully, for all of you guys, when your investment returns have a larger impact on your net worth than your earnings and savings. As a result, the richer you are, the more dismayed you will be to lose money.

Because no matter what you do, you can't really make a difference through working harder or longer and saving more. And the reason we all continue to fight in this really difficult world is because we have hope. But eventually, our hope fades because our brains and our bodies slow down.

When we're younger, we often think to ourselves, we're invisible. We can do anything. Nothing's going to hurt us. Then eventually, we start experiencing the realities of aging. And due to these fading abilities, we must bring down our risk exposure as we age. The only way most of us can rescue our investments after a market swoon is through contributions from earned income, i.e.

our salaries. And to understand reward, we must first understand risk. Since 1929, the median bear market price decline is about 33.5%, while the average bear market price decline is about 35.4%. Therefore, it's reasonable to assume that the bear market could bring equity valuations down by 35% over an 8 to 12-month period.

And if you look at the post, you can see this chart that chronicles the bear market. So most people just regularly invest in stocks over time through dollar cost averaging. They have little concept of whether the amount of stocks they have as part of their portfolio or their net worth is risk appropriate.

Hence, to quantify your risk tolerance based on your existing portfolio, use the following formula. And this is part of financial seer. Public equity exposure times 35% divided by monthly gross income. So let's say you have $500,000 in equities and you make $10,000 a month. To quantify your risk tolerance, the formula is simply 500,000 times 35%, where 35% is the average decline in a bear market, and you get $175,000.

And then you divide that by $10,000, which is your monthly gross income, to get 17.5 months. In other words, the formula tells you that to make up for your potential losses, you have to work an additional 17.5 months of your life, and that is gross income only. So because you have to pay for taxes, you're probably going to have to work closer to 22-plus months.

And then because you have to pay for basic living expenses, you probably need to work more than 22 months to make up for that loss. So in other words, that risk tolerance multiple of 17.5 is really-- well, you probably need to multiply by 1.2 to 3 times to get the real amount of months that you need to work to make up for your losses.

And just think about this classic scenario-- 68-year-old guy, retired with a million-dollar portfolio, living off $20,000 a year in Social Security, and $20,000 in dividend income from his portfolio. If his portfolio loses 30%, that's going to be really, really, really tough. We're talking losing $300,000. And if you have a fixed income of $20,000 a year from Social Security, it's practically impossible to make that up.

The only thing the retiree can do is pray the market eventually goes up while also cutting costs. Now, the second part of financial seer is to figure out what the appropriate equity exposure should be based on the risk tolerance multiple. So here's another formula. Your max equity exposure equals your monthly salary times 18 divided by 35%.

So what is 18? 18 is my recommended risk tolerance multiple, where on a gross monthly salary basis, you don't want to risk more than 18 months worth of gross salary on your equity investments. And 35%, again, is using the average bear market declined in your public investment portfolio. In other words, if you make $10,000 a month, the most you should risk is a $180,000 loss on a $514,000 pure equity portfolio.

Now, your portfolio can obviously be more than $514,000 in this equation. You can have 250,000 in AAA-rated municipal bonds, if you wish, for a reasonable 67%, 33% equity fixed income split with a total portfolio size of 764,000. You basically have to adjust assumptions as you see fit. Maybe you only think the bear market will only decline by 25%.

Well, then you can just replace 35% with 25%. And the result would be $10,000 salary times 18 divided by 25%. So you can actually have 720,000 of maximum equity exposure. Maybe you see yourself getting promoted and earning 20% yearly earnings increases for the next five years. Maybe you can increase, therefore, your equity risk tolerance multiple to 36, maybe, from 18, and maybe, as a result, you could have 1.44 million in equity exposure using a 25% denominator as the bear market scenario.

Just remember, whatever your gross risk tolerance multiple is, you're going to have to increase it by 1.2 to 3 times to truly calculate how many years you will need to work to recover from your bear market losses due to taxes and general living expenses. At the end of the day, it's a judgment call regarding how much equity risk you should take.

If you've quadrupled your net worth after a nine-year bull run, it's probably wise to lower your risk exposure multiple. Conversely, after 30% correction in equities, it's probably wise to increase your risk exposure multiple. Only you can decide how much more you're willing to work to make up for those losses.

The closer you get to retirement, the lower your multiple should be. Nobody wants to get close to being financially free only to break a leg and get carted off in an ambulance. I hope the financial samurai equity exposure rule helps you take the subjective term of risk tolerance, because everybody just throws that around, and shapes it into something more quantifiable.

You now have a concrete way of determining your equity exposure and risk tolerance. As for 2019, well, earnings are set to grow by only about 6% to 7% from about 20-plus percent in 2018. But the good thing is the market corrected. We're back to historical averages on a P level.

And I could easily see the market go up 10%. And at the same time, I could easily see the market go down 10%. So for me, in particular, I'm looking to lock in wins. And I'm doing that by paying down some mortgage debt and also taking advantage of shorter-term interest rates.

For example, SITBank has a 2.45% money market account now. I mean, that's huge. And you can sign up at financialsamurai.com/citbank savings to get that 2.45%. That's pretty much the same as my 5-1 arm mortgage rate. So basically, I'm living for free. You really want to lock in some games.

Yes, continue to invest, but make sure it's in a risk-appropriate manner. My current allocation is about 40%, 45% stocks, 50% to 60%, fixed income. And it's just going to depend. If I see opportunity, I'm going to take it. And if S&P 500 gets back to 2,800, I'm probably going to sell a lot more equities.

And hopefully, ironically, hopefully, rates continue to go higher so I can get that risk-free rate of return. Thanks so much, everybody.