Before you start investing, it’s a good idea to engage in some self-reflection and determine what type of investor you are. When you’re thinking about the types of securities you want to invest in, there are several things you should consider, including your goals, expected return, liquidity needs, time horizon and tolerance for risk. These items are included in what is known as your Investment Policy Statement. Your Investment Policy Statement is your blueprint for your future portfolio and will help you decide how to distribute your investments over different asset classes, which is called your asset allocation strategy.
Your Investment Policy Statement requires you to think about your short term and long term goals before creating an investing strategy. This is because your portfolio composition will differ depending on what you hope to achieve by investing. For example, if you are investing for retirement in 40 years versus investing for a shorter term goal, such as buying a car, your portfolio may be comprised of less liquid, riskier investments with the intent of generating a higher rate of return.
What is your expected return on your investments? If you desire a higher return, you may consider investing in higher yield debt or high-growth stocks as opposed to government bonds and blue-chip stocks. Keep in mind, though, that having higher expected returns usually requires you to take on more risk.
Another important item to consider is your liquidity needs. How soon will you need access to the money you are investing? In the event of a financial emergency, will you need to liquidate your holdings? Once you understand your liquidity needs, you will have an easier time creating an asset allocation plan. For example, if you know there’s a chance you will need access to your money in the near future, you may decide to keep a larger portion of your investment in short-term liquid securities, such as money market securities or fixed income, such as treasuries, rather than investing in a less liquid asset, such as real estate.
After you determine your goals and liquidity needs, your time horizon is relatively easy to figure out—when do you need the money that you are investing? If you need the money to purchase a home in 5 years, then your time horizon is short. If, however, you need the money to retire in 50 years, your time horizon is long. Knowing your time horizon will help you determine the amount of risk you should be willing to take in your investing. Generally, the longer your time horizon, the more risk you can take.
Assessing your investing goals, liquidity needs, and time horizon will help you determine the amount of risk you can take afford to take on. Generally speaking, if your time horizon is long and you do not need access to your money in the near future, you can take on more risk. However, you should also reflect on how much risk you can tolerate on a personal level. Your risk tolerance, or what I like to call your “investing personality,” represents your attitude towards risk-taking and what types of investments you are likely to be comfortable making.
You may be familiar with the risk-reward concept in investing. The more risk you take on, the greater your potential reward. Conversely, the less risk you take on, the lower your potential reward. Anytime you invest, there is always a risk that your investment will decline in value, which would cause you to lose money. What you need to decide, is how much money you are comfortable potentially losing or how much tolerance you have for volatility in the value of your investments. Is the riskiness of a certain investment worth the potential reward? Or, are you more comfortable playing it safe and investing in something with lower risk, but less potential for reward?
Check out the four investing personalities below to help you determine your risk tolerance and gain a better understanding of what types of investments may be right for you.
The Conservative Investor
If one of your investments decreased by a significant amount on a single day, what would you do? Would you sell the remainder of your investment in order to avoid further losses? In the course of your everyday life, do you like to play it safe? Do you make sure to drive the speed limit to avoid getting a speeding ticket or causing an accident? Was Little House on the Prairie your favorite television show growing up?
If you answered yes to most of these questions, you are most likely a conservative investor and are probably most comfortable making investments with lower volatility and expected returns. Some examples of instruments you may invest in are treasuries, money market securities, utilities, and blue-chip or large-cap equities. Some conservative investors may be tempted to avoid the stock market entirely. However, in order to create a diversified portfolio, which helps reduce risk, it is generally prudent to allocate some of your investments to equities.
The Conservative to Moderate Investor
If one of your investments decreased by significant amount on a single day, would you sell a portion of the investment and retain the rest? Can you tolerate day-to-day fluctuations in the value of your investments? Do you strive to weigh the pros and cons of every decision and determine the most likely outcome? Are you comfortable taking a small amount of risk? Do you enjoy problem-solving crime shows like CSI and Blue Bloods?
If you answered “yes” to most of these questions, you’re risk tolerance is probably more moderate. As a more moderate investor, you will most likely feel comfortable having a larger portion of your investments in blue-chip or large-cap equities order to provide your portfolio a higher probability to increase in value over time.
The Moderate to Aggressive Investor
If one of your investments decreased by a large amount in one day, would you make the decision to hold the investment in hopes that its value would go back up? Do you hold the belief that in order to get what you want in life, you have to take risks? Do you enjoy carefree comedies, such as Parks and Recreation, above all other forms of entertainment?
If you found yourself answering “yes” to these questions, you are, in all likelihood, a more aggressive investor. You believe that in order to get a large reward, you may need to take higher risk. Consequently, you are willing to invest in more risky securities, within reason. You may be comfortable spreading most of your investments across large and small cap stocks, international equities, high yield debt, and real estate.
The Aggressive to Very Aggressive Investor
If you experienced a large dip in one of your investments would you decide to maintain your current holdings and buy more of the investment? Are you a thrill seeker? Do you enjoy gambling? Do you have an “all or nothing” attitude about life? Do you emulate the Wolf of Wall Street or enjoy entertainment in which the protagonist takes on large risks for potentially large rewards?
If you believe the above questions describe your personality, you are probably an aggressive to very aggressive investor. You are comfortable taking large risks for the possibility of a highly positive outcome. You may be comfortable being a more speculative investor and investing all your assets in equities, including large and small cap stocks, emerging market securities, venture capital, futures, or stock options.
Where do you go from here?
Now that you have a better understanding of yourself as an investor, it should be easier for you to start choosing investments and building the portfolio that’s right for you. You will want to use your investing time horizon, liquidity needs, and investing personality (or risk tolerance) to create an asset allocation plan for your investments.