The first thing about learning how to invest in the stock market is to know what kind of investor risk profile you have. In so doing, you will determine how best to asset allocate your savings among various asset classes. Not knowing what kind of profile you have or what you are investing in may cost you financially, as for example in cases when an 80 year old is found to own very aggressive funds, or a single person in their twenties is invested purely in bonds, or someone who is a complete nervous nelly is trying their hand with commodities. Not having the stomach or right disposition may make you cut in and out of investments in a way that is deleterious to your portfolio and before long, you will find yourself wondering why you are left with a smidgen of what you had initially.
What’s Your Investment Risk Profile? Know Yourself!
Investing is a way to make your money work for you so that you can take calculated risks for the promise of a better reward: much better than simply stuffing your money in a hidden nook somewhere in your house. The more you know about risk and how it can affect you and your situation, the better off you will be. Bottom-line: there is a law that states that your returns are directly proportional to the risk you take. I found this definition of risk to be quite spot on:
The concept of “risk” in investment has to do with volatility or how widely the price of a stock or mutual fund fluctuates. The wider the fluctuations, the higher the risk. This is because you stand to make and also lose more money, compared to a fund that doesn’t fluctuate as wildly.
Following on from this investment concept, “aggressive” or “high risk” means that a mutual fund or stock can potentially achieve higher returns because of greater volatility. In contrast, “low risk” or “conservative” means that a stock or mutual fund will trade close to its historical average prices and will tend to be quite stable.
The following test and many others like it tend to concentrate on finding out your age, strength of income, family situation, current financial picture, and overall tendencies and investment disposition. I would say that one other important element in figuring out where you stand as an investor is how sophisticated you are and what kind of experience you have with investing. Ultimately, your overall background and attitude about investing will affect how you should proceed; definitely consider your personal comfort and peace of mind when formulating your investment strategies!
As a starting point, here is an example of a test that shows what kind of investor you are:
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Indicate your age group
Over 50
40-50
Under 40 -
Indicate your annual income group
Below 40,000
40,000 – 60,000
Over 60,000 -
How long do you expect to have others substantially dependent on you for financial support?
More than 10 years
Up to 10 years
Not at all -
How do you see the security of your job or business over the next 5 years?
Not good
Satisfactory
Very Good -
Relative to your goals, what level of savings and other assets do you have now?
Very Low
On Track
High -
Which description best fits you?
Conservative, worry about money
I like things to go according to my plans – I like to be in control
Very comfortable in taking a calculated risk with money
Find the test here, where it will give you actual results.
It seems like every single financial institution out there has their own take on the financial profile test. They all ask the question, “What Kind Of Investor Are You?”, and from there suggest the asset allocation or program that’s right for you. Here is one quiz along similar lines by CNN Money.
Know Your Goals
Along with determining your current situation and risk profile, you also need to have a grasp on what your financial goals are. You can start by asking yourself these questions:
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How long are you planning to keep invested?
This will determine the duration of your investment. Typically, you should consider your goals to have the following durations:
Short term – 1 to 3 years (before you need the use of your money)
Medium term – 3 to 7 years
Long term – over 7 years -
Are you aiming for income or growth?
If you are planning to use your investment returns as money to live on, then most likely you should be investing for income. If you are gunning for capital gains and desiring to grow your money as much as possible by setting it aside for the longer haul, then your capital would do well in a growth vehicle.
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Do you need quick access to your money?
If so then liquidity is important to you. Note that liquidity does not necessarily equate with safety. Liquidity is the ability or ease with which assets can be converted into cash without taking a loss. Within each asset class (that being, cash, bonds or stocks, for instance), the degree of liquidity may vary. Cash accounts, some bond funds and even stocks have fairly high liquidity, whereas real estate and other hard assets such as jewelry or even something as innocuous as a certificate of deposit (CD) have relatively lower liquidity. Something that ranks as pretty illiquid is your 529 account or a retirement account.
Depending on how you replied to these questions, you may get a clearer idea of what it is you’d like to have in your investment plan.
My Test Results and What Kind of Investor I Am
When I took the test, it showed that I had a moderately aggressive or medium risk investor profile. Here is what it said:
You are a Medium Risk investor. You will probably be comfortable in having your long-term savings in medium risk investments. A well balanced fund with around 50% in shares and property. (Note – the property element can be obtained through shares in property companies).
Other categories:
Low Risk investor. You should definitely favor lower risk investment. Make sure any long-term savings money is well spread over the different kinds of investments (cash, property and shares) with a higher proportion of cash (savings and fixed interest) than property and shares.
High Risk investor. Your circumstances suggest that you could have a significant proportion of your savings in higher risk shares. However, diversification in any share portfolio is still important. If this category concerns you then select ‘Medium Risk’.
That sounds about right, though knowing myself, I am probably most comfortable with a very simple investing approach (check out my simplest investment portfolio). I started out with little knowledge of more exotic markets such as gold, commodities or currency markets, but I’m gradually learning more about these types of investments (and building positions in them). Also, I found that by simply following a steady, sound investing program, I’ve been able to achieve returns that I have been satisfied with, which typically mirrored equity market returns. So as far as my investment plan goes, I shall discuss it further when I tackle the subject of asset allocation.
Each person has a different approach to how they create their investment plans. Some are very independent while others may need some professional help. I fall right in the middle of that as someone who tries to be aware of the investment atmosphere through periodicals and the media, and will take into account what many analysts offer, but will do the actual investing based on my own decisions.
As an investor, I know myself enough to say that I don’t over analyze or tend to get stuck on minutiae. I am a more “intuitive” investor and many times, I go by my gut feeling about opportunities, markets, worldwide events and community sentiment and psychology. I am quite contrarian in my approach though it hasn’t stopped me from joining the herd once in a while. My key approach is one of controlling or managing risk where I can, and not try to beat the market or the big boys who make a living playing it. And most of all, I try to make things simple and stick to the basics such as indexing, proper asset allocation and diversification, with just a little dash of spice once in a while, perhaps in the form of sector plays or higher concentrations in individual stocks or even a little bit of market timing.
Consider this premise, as with many things in life: if there’s anything else that should be taken into moderation, then it should be risk.
So how about you? What kind of investor are you?
Copyright © 2011 The Digerati Life. All Rights Reserved.
{ 8 comments… read them below or add one }
Investors should always know the amount of risk they are taking on. Especially the way the markets have been going. Up 1 day down 2. The volatility is way high and it will be that way for awhile.
Excellent start!! You have mentioned all the basic things one need to check.
Great article!
Thanks, this is good as I don’t know much about investing in the market.
Matt
I think a couple of things need to be added. People need to think through how they will act when the value of their portfolio drops by 25% because these days are coming. There will likely be at least 2 years out of the next 10 where this happens. Many investors are emotional and sell out near the bottom. Also, many investors can’t stand the ups and downs of the market. They check their portfolios constantly and work themselves into a dither.
Think through these things before they happen. The emotional side of investing is what ruins individual investors.
Bottom-line: there is a law that states that your returns are directly proportional to the risk you take.
This law has indeed been proposed by the Fama Party. However, it is strongly opposed by the Shiller Party!
In all seriousness, you are here stating a “law” of those who believe in Modern Portfolio Theory or the Efficient Market Theory or the Buy-and-Hold Model for understanding how stock investing works, SVB. There are a good number of people who do not agree that this is a “law.”
My view is that valuations affect long-term returns (there is now 30 years of academic research showing this to be so). If this is so, stocks obviously provide lower returns when they are high-priced than they do when they are fairly priced or low priced. We also see that all stock crashes take place at times when stocks are high priced. So risk is higher and returns are lower at times of high prices. High risk is accompanied by low returns, not high returns!
The idea that we must accept risk to obtain good returns is a dangerous myth, in my view. All stock risk is telescoped into those times when valuations are high. For those willing to refrain from buying stocks when prices are insanely dangerous, stocks are a low-risk asset class. I understand that many smart and good people have a hard time accepting this. I encourage skeptics to check out the historical return data. There has never yet in 140 years of stock history been a time when stocks purchased at times of reasonable prices provided poor long-term returns (but the long-term return has been poor in every case in which stocks were purchased at times of insanely high prices).
Rob
Just a few thought:
1. How is it possible to generate ‘wealth’ when you expose your money to risk?
2. Returns are unpredictable in the stock market. The strategy is more like a ‘high risk unknown return’ one.
3. There is no correlation between volatility (risk) and return. The data proves this.
4. Some crazy assumptions about MPT: i. Price movements are smooth from one moment to the next. ii. Markets are rational.
The theory behind how portfolios are constructed is flawed, which means that investing is inherently risky.
@DIY Investor, wasn’t this the case in 2008? The scenario you bring up has already occurred very recently, particularly in the real estate arena…. People have been losing their shirts everywhere…! I feel that my emotions were sorely tested then and what I’ve found is that the first time it happens tends to be the toughest. Once you’ve gone through the wringer several times, it gets less difficult — perhaps because you’ve learned some lessons, you get accustomed to the instability, you’re more prepared (emotionally). So as an investor for over two decades now, I feel that I’ve more or less seen some of the higher highs and lower lows that can be thrown at me by the markets. I’ve since become more diversified and perhaps more conservative in my stance with the financial markets. Who knows though what other turmoil will be in store in the future — what we can in fact guarantee is that something will be out there to shake things up again!
@Rob, I was indeed stating a law. You pointed it out — it was one law that one faction of the investment community espouses and believes in. It’s good that you also pointed out the importance of valuation. It’s one factor that some of us don’t take into consideration when assessing risk. But my take on it is that something is risky not because of valuation but because of volatility. So when I said “returns and risk go hand in hand”, I meant that if you buy into a volatile asset, you can expect higher returns. Now from what I gather, you are pegging risk to valuation. So perhaps we are describing risk in different ways?
@WayToWealthGuy, Thanks for the interesting pointers. I’m actually not (yet) heavily schooled in investing mechanics like some of you are, but I try to operate on common sense and some of my own experiences. And I learn new things everyday. So yeah, I enjoy reading about the various views and theories on this matter, esp. when data backs it up (or not). 🙂 I’d like to explore what you mean by The theory behind how portfolios are constructed is flawed, which means that investing is inherently risky. So you are saying that investing will always be risky regardless of how you construct your portfolio? And you asked the question about wealth generation and risk — so isn’t it the case that wealth generation is always tied to some degree of risk, whether it be in finance or business?
Now from what I gather, you are pegging risk to valuation. So perhaps we are describing risk in different ways?
Yes, that’s so.
There’s one school of thought that goes by different names (Buy-and-Hold, Modern Portfolio Theory, Efficient Market Theory) that defines risk (and just about everything else) in one way and there’s another school of thought (Behavioral Finance, Valuation-Informed Indexing, the Shiller/Irrational Exuberance School) that defines risk in another way. The former school has been dominant for some time but the latter school is gaining more adherents since the crash and the economic crisis.
I make a point of trying to remind people wherever I go that the former school is not necessarily right in its understanding of things. There are lots of good and smart people who belong to this school. But I don’t want people to think that these questions have been settled, that there is some kind of scientific proof that Buy-and-Hold/Modern Portfolio Theory properly describes reality. It is a theory. There are people who believe in it. There are also lots of people who do not believe in it even a little bit.
The Behavioral Finance School would say that “risk” is not volatility but the potential of losing money. At times of low or moderate valuations, they would say that the risk associated with stock investing is just about nil. They would also say that the likely return at such times is high. So they say the opposite of what the MPT people say. Instead of saying that you have to take on risk to obtain return, they say that it is when risk is least that returns are greatest.
It’s highly confusing to have two schools saying the opposite thing! So I fully understand why this gets messy. My aim is to help more people sort this all out. I think that basic problem is that the Buy-and-Hold/MPT model has been pushed so hard and for so long that many have come to believe that that is the only legitimate model out there.
Rob