6) Investing 101: Knowing Yourself

by · August 23, 2010

Ever heard of the saying “Know Thyself”? This is very applicable in the context of investing. Success depends on ensuring that your investment strategy fits your personal characteristics. Not all specific investing vehicles and methods are suitable for all investors. Even though all investors have one common objective in general – which is to make money – each one comes from a diverse background and has different needs. There are many factors that determine which path is best for an investor.

Investment Objectives

Investors only have a few factors to consider when deciding where to put their money: Safety of capital, current income and capital appreciation. Making an investment will also depend on a person’s age, position in life and personal circumstances. For example, a 75-year-old widow living off of her retirement portfolio is far more interested in preserving the value of her investments because she needs income from her investments to survive. On the other hand, a young business executive can afford to be more aggressive when it comes to investment decisions and strategies. The latter has time and a full-time job on his side.

An investor’s objectives are very much affected by his or her financial position. If you have millions in the bank, putting down $100,000 on a speculative real estate investment is peanuts. You can afford to risk the money because it is only a small percentage of your overall worth. If you were just starting out in investing and only have a few thousand dollars saved up, you can’t afford to risk losing your money in a speculative venture. Regardless of the potential returns of a risky investment, speculation is not appropriate for your financial position.

In investing, time plays a big role. As a general rule, the shorter your time horizon, the more conservative you should be in your investments. If you are still in your 20s you have plenty of time to make up for the losses you might incur along the way. At the same time, if you start young, you have the power of compounding on your side. Remember the example of Pam and Sam in the previous section?

When you are about to retire, it is a different story. It is important that you either safeguard or increase the money you have accumulated. Soon enough you will be accessing your investments and you don’t want to expose all of your money to volatility. It won’t be wise to put your money at risk because of a market slump right before you need to start accessing your assets.

Personality

The personality of each individual plays a role in investing. Each person has a different style. Some people love the thrill of a risk, while some prefer it slow and safe. There are people that love to know more about financial statements and crunching numbers. To others, looking at a balance sheet, income statement and stock analysis is as exciting as watching paint dry. Still, there are others who might not have the time to plow through prospectuses and financial statements. All these personality traits will help determine an individuals investing path.

The “key organ for investing is the stomach, not the brain,” said Peter Lynch, one of the greatest investors of all time. Simply put, you need to know how much risk in your investments can you stomach. You will have to figure this out for yourself. One way of knowing is best said in an old investing maxim: “you’ve taken on too much risk when you can’t sleep at night because you are worrying about your investments.”

Putting It All Together: Your Risk Tolerance

It is clear to you by now that one of the main things that determines what works best for an investor is the capacity to take on risk. Earlier, we have mentioned some core factors that determine risk tolerance. The important point to remember is that an investment is not the same for all people. Each individual’s situation is different. Keep this at the back of your mind for upcoming sections of this tutorial.