With various investment options available in the market today, it is not enoughfor investors to merely have an objective of “to profit” or “to gain wealth” when they invest. While all investment vehicles will aim to earn a positive return for investors, the level of risk associated with each investment varies greatly.
For starters, ask yourself these simple questions:
- Are you investing for the short- or long-term?
- Can you handle fluctuations in the market and comfortably accept that your portfolio can lose money?
- Or would you prefer to trade off risks to avoid huge losses but gain only a small return on your investment?
These are just some of the questions you might ask yourself as you wade through investment vehicles. You will have to start with getting to know yourself more and your risk tolerance. Knowing your level of Risk Tolerance and, ultimately, Investment Objective is VERY IMPORTANT and SHOULD NOT BE DISREGARDED before you even start making your first investment. Knowing these two will help you determine what investment is suited for you to help you manage your expectations.
All right, let’s get to it!
Know Your Risk Tolerance
Not all people can handle relatively high levels of risk. While some can take erratic price fluctuations in the stock market, others prefer low-risk, low-return investments like Time Deposits. Historically, though, the return of stocks have significantly outperformed that of Time Deposits in the long run, but in the process, one may have to take on more risk in order to gain more benefit.
The level of risk you can tolerate is dependent on various factors like level of investment knowledge, education, marital status, experiences, culture, and beliefs, but for this material, we will focus on what a lot of investment managers use as a starting point for determining risk tolerance: life phases.
There are three (3) basic phases that people typically go through, namely:
1. Accumulation Phase
An investor in his 20s or early 30s normally belongs to the phase called the accumulation phase. Some characteristics of investors in this phase:
- Your net worth is probably fairly small.
- You might not have a lot of money, but you do have one important commodity: time.
- Someday, you would want to have children, send them to college and then retire.
- Once your immediate investment goals are met – owning a car, making that down payment for a house – you will still have a long time horizon on other investments.
- You will be most interested in growth and can make some fairly high-risk investments with the expectation of making above average returns.
2. Consolidation Phase
In his mid-30s, the investor will typically move into the consolidation phase. Some traits of people in this phase:
- Retirement and estate planning are your biggest concerns.
- Your debts should be nearly paid off, your children’s college expenses should be funded, and your earnings should exceed his expenses.
- You will likely stay in this phase through your peak earning years, until just before retirement.
- You still have a decade or two before you eventually retire, so during this phase, you might have a moderate tolerance for risk.
3. Spending Phase And Gifting Phase
As the investor approaches retirement, he enters the spending phase. What usually happens:
- Your daily living expenses are covered provided by pensions, interest in retirement accounts, or a steady, predictable income from past investments.
- You have no need to speculate aggressively and desire no financial surprises. The worst that can happen is that you could lose your entire nest-egg; the best that can happen is that you will leave your heirs more of the money you never had a chance to spend on yourself.
- It follows, then, that you are likely to be more risk-averse at this point. Your biggest concern is inflation, and you must incur some degree of risk to cover a potentially shrinking peso.
- If you are financially gifted, the spending phase might coincide with the GIFTING PHASE, during which you will provide for friends and relatives or contribute to charity.
Of course, going through these phases sequentially is ideal but not necessarily true for everyone. Some who are born rich may not necessarily go through a decade of accumulation phase anymore and, instead, proceed directly to the consolidation phase. There might be some who would struggle financially for most of their years and even if they have already reached their 50s or 60s, are still in their consolidation phase.
What the concept of life phases merely teach us is to identify our starting point for determining our level of risk tolerance so we can ultimately decide the appropriate investment vehicles we should be investing in. Once you have figured that out, proceed to the next step: Knowing your Investment Objective.
Know Your Investment Objective
As you read above, the older you typically get and the greater the number of people who rely on you for support, the more your aversion to risk or losses will be. Now, given what you think your level of risk tolerance is, here are the four (4) different Investment Objectives that you might want to consider for yourself:
1. Capital Preservation
Risk-averse investors and/or those in the spending and gifting phases of their life are usually most interested in preserving their capital. This is the most conservative investment strategy, and it is intended solely to avoid risk of loss. Less risk, of course, means less return.
For this investor, safety is extremely important – even to the extent of giving up return for security. The logic is clear: If they are already retired and yet lost money through foolish investments, it is unlikely that they will get a chance to replace it.
What investment options are available to people with a Capital Preservation objective?
Low-yielding bonds, money market funds, and Time Deposits are usually the foundation of a capital preservation strategy.
2. Current Income
Current income, meanwhile, is the strategy focused on getting returns on investment, although not necessarily huge returns, as quickly as possible.
Investments using this objective produce current income on a regular basis that will be used for living expenses. It is linked to the Capital Preservation objective in the sense that the capital is invested to create an income stream but the principal is not touched and preferably will not incur losses, yet provides cash for current needs (such as, tuition for grandchildren’s education, payment for a vacation, or monthly amortization for a car or housing loan).
For investors with a Current Income objective, high-interest bonds and high-dividend stocks are the mainstays in one’s portfolio.
3. Capital Appreciation
Capital appreciation is the objective of growing, rather than simply preserving, capital in the long term. To accomplish this goal, the investment return should exceed the expected inflation. Inflation wipes out the value of a currency, so growing one’s money at a rate that exceeds inflation is the goal in order to maintain the value of money.
Stocks, in general, are the preferred investment of those with a Capital Appreciation objective. In the past, the returns of stocks have generally outpaced the inflation rate.
A growth stock is a type of stock that usually does not offer huge dividends but the payoff with this strategy is in selling the stock years from now for many multiples of what you paid for it today.
A speculative stock, meanwhile, could provide huge returns in a short span of time. Speculative stocks are those of companies speculated (not confirmed) to produce huge revenues and net income in the future, thereby producing huge gains to investors.
Take note, still, that there is a certain level of risk involved in stock investing. Paper losses (meaning, unrealized losses) could occur especially in the short-term, but investors with a Capital Appreciation objective recognize that they have to take some level of risk in order to produce an above average payoff in the future.
4. Total Return
A Total Return objective factors in both capital appreciation – how fast the share price grows – and current income — regular income to cover short-term expenses.
Total return is sometimes called growth-with-income.
A typical Total Return portfolio has a certain percentage of investment allocated to growth or speculative stocks, and the rest on blue chip stocks, high-dividend yield stocks, or bonds.
Just as people do not necessarily fit into convenient investment phases, we tend not to have just one investment objective. Be sure you select and manage your investment portfolio that suits your own investment objective/s!
It is also important to remember that, because of varying investment risks and returns, you must also properly manage your expectations.
For example: if you are a risk-averse investor with a capital preservation objective, you should not consider high-risk speculative stocks.
Also, if you are investing in stocks for capital appreciation, keep in mind that this objective is achieved in the long-term and, thus, short-term price changes should not concern you!
Have you decided now what your investment objective is?