Wednesday, March 18, 2009

This is a guest post by Dana. Dana blogs at the Investoralist, where she discusses investing in today’s media-obsessed, amnesic and sound-bite driven world, and provides discussion based on a holistic look at the macro-investing environment. 

If you are interested in writing a guest post for Money and Such, please contact me at the address provided on the left column, or by leaving a comment anywhere on the site.

The path to financial success is steadier if you are able to assess yourself honestly.  For most people, putting their savings in high yield saving accounts, money market funds, bonds, or GICs with inflation protection are more than sufficient.  Clearly, the general public is not satisfied with this level of simplicity when it comes to money.  Pushed and prodded by greedy brokers, everyone from retired pensioners to starter families became deeply invested in this equity market.

In face of the market carnage, what do you need to know about yourself to ensure that you will invest wisely going forward?

Know your investment horizon.  A lot of people got into trouble because they failed to line up their assets and liabilities with respect to their investment horizon and financial obligations.  In banking, they call this liquidity matching.  Sure, in the long run, your money will go up in the market.  In the long run, we are all dead.  So if you don’t want to substitute impending retirement for a lifetime of involuntary employment, or have to tell your kids to hold off college for a couple of decades while the market recovers, then match your financial obligations with where your money’s going.

Know your risk tolerance.  What kind of market fluctuation would keep you up at night?  That’s the most unscientific, but gut-instinct question asked by investment advisors when assessing their client’s risk profile.  Then they slot you in a risk category. But it’s important to understand that your risk tolerance is precisely that, YOUR risk tolerance.  Not what your broker or investment representative tells you. You may fit into some broad categorization of risk adverseness based on your age, gender, investing experience or education.  But at the end of the day, do you know what constitutes a risky investment to you?  Who knows, maybe you like the thrills of seeing your portfolio moving up or down by 20% everyday.  But for the vast majority of us that can’t stomach that kind of roller coaster ride, consider the question truthfully.  Learn as much as you can about where your money is going, learn even more, then imagine what happens when you lose it all.   

Line up the cash flows of your career and your investing life.  Conventional wisdom suggests that entrepreneurs have riskier careers.  It’s not necessarily the career that is more volatile, but the cash flow. Small businesses will most likely experience more problems meeting their cash flow needs than their larger counterparts during a financial downturn.  For an entrepreneur, that means your business cash flows may be dropping at a time when you need it most – when cash flow is tight.  To protect yourself and not over-extend risks to both your asset base and cash flow situation, does it not make sense for an entrepreneur to be more conservative in his investing life?

Address the specificity of your situation. Nobody understands your financial needs more precisely than you.  You need to be clear on the specific goals that you have in mind, and guard against potential setbacks in life and career uncertainties that may require a safer portfolio.  If you have short-term cash flow needs, set that money aside somewhere safe.  If you have pressing medical needs or suspect that you do, if you have a wedding or kids on the way, all these have to be planned for.  Similarly, if you are looking at career changes or at starting a business, again, your risk tolerance will be different from that of the Joe average next door.

End of the day, there are two kinds of risks when it comes to investing.  One in lost opportunities, when you’re outside looking in, wishing you were in the market and riding an upward swing.  But the thing is, there are always more opportunities as long as you have capital and patience.  The other is when you’re in the market and looking out, wishing you were not invested because you’re losing money.  Most of us are probably pulling our hairs out because we’re in the latter group.  So when the next bull market beckons with its ever-so-seductive calls of high returns, pause, and have an honest question and answer session with yourself.

Editor's Note: I largely agree with Dana's main points, but I put the emphasis in slightly different places. You can read more on my views regarding asset allocation and building a portfolio that's right for you, in these previous posts.

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3 comments:

Trevor @ Financial Nut said...

That risk tolerance is all about time. The younger you are, the more stocks you should have in your portfolio. I'm only 24 so I'm fully-loaded with a portfolio of highly aggressive stocks.

That's why I've lost half of it in the last year. :)

Shadox said...

Trevor,

That's not always true. In my opinion being able to sleep at night is more important than your financial returns. Many people feel a great deal of discomfort about risking a large percentage of their money and these folks would be very wise to have a more conservative asset allocation.

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