Tuesday, July 17, 2007

Stomach for Risk & Appetite for Returns - Part II

In yesterday's post I proposed a link between the return offered on an investment and the risk attached to that investment option. I also entertained the notion that the fact that an asset class (or an entire market) shows dramatic historic returns is an indication that it carries a high degree of risk.

My mother does not make the connection between risk and return. She understands the concept of risk, and understands the concept of return, she simply does not understand that the two are intimately connected. My mother's appetite for returns is high. She is always looking for ways to increase the returns on her investment. Unfortunately, and paradoxically, she is also extremely risk averse. For one thing, she checks the performance of her investments on a daily basis. So far, this is not an issue. I do the same thing myself. The problem is that if an investment fails to generate a high enough return for her taste, she sells and moves on to the next hot-ticket within days. Until she does, she complains and is unhappy about her investments.

If you are a day-trader, good for you. I don't believe in day-trading, but if you think you can make money that way, more power to you. You perform a valuable service for the capital markets by adding liquidity and increasing the market's efficiency. However, if you are Shadox's mother and your training and understanding of investment vehicles is limited to their return over the past 30 days, you are probably doing yourself a very big disservice by trading frequently.

I think that the number one thing any new investor must do is to develop a complete understanding of his appetite for risk. Everyone thinks that they can take more risk when the market is going up, but will you feel the same way if your investments lose 20% in a month? My mom's ability to stomach risk is far lower than her appetite for returns. This both makes her nervous and causes her to make bad financial decisions such as selling her investments just when they are about to hit bottom.

If I were asked to offer just one piece of financial advice it would be this: only invest in a way that will allow you to sleep at night. Not following this advice can only lead to unhappiness and bad financial decisions.

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