Earlier this week I had a conversation with my younger brother about his personal finances. I was very pleased to learn that my brother is saving and investing his money - no debt for him. On the flip side, I also learned that he is making his investment decisions without a coherent investment strategy and without defining fixed goals for his portfolio.
Smart investing starts with setting clearly defined goals. The goals that you set, together with your tolerance for risk, largely determine your optimal investment strategy. My brother, who is in his mid-twenties, could not tell me what he is saving for or define the time horizon for his investments. He is unclear on the concept of risk vs. return, and is largely investing based on the annual results published by the various mutual funds, without consideration for asset classes, diversification or investment cost.
Since he is unclear as to the time horizon for his investments, and is invested largely in volatile stock funds, my opinion is that he is accepting more risk than is appropriate for his situation. Given his age and personal status, most of his personal goals are likely to be shorter term goals (under 5 years). Investing all your money in the stock market with such a limited time horizon is a risky proposition. If I were in his shoes, I would place no more than 50% of my assets in the stock market and put the rest in a combination of bonds and high-yield money market funds.
I also think that my brother is over estimating his appetite for risk, having never gone through a real bear market. He marvels at the fact that his investments have yielded about 10% year-to-date, but like many other investors I don't think that he grasps the connection between high-yields and high-risk. The fact that an asset yields high returns is typically an indication of the higher level of risks associated with that asset. The higher return is the payment investors receive for being willing to accept that added level of risk. I think that this is a topic worth a post on its own, and will take up the challenge in the coming weeks.
My brother is already saving for his retirement (there might be some sense in him after all!). Appropriately, his retirement assets are all investing in the stock market. However, he is not yet a convert to the Index Fund cause, still opting for actively managed funds. I am trying to get him to read my recent post titled Beating the Market of Faking It, and hopefully with time I will be able to help him to see the light.
Over all, I am positively surprised. My brother is debt free and is thinking about personal finance. Yesterday he even went to a personal finance seminar. Now I only need to teach him not to buy swamps and bridges, and he'll be fine.