Tuesday, June 22, 2010

4 Things You Need to Know Before You Invest Your Hard-earned Money (Part 2)

3. Your investment horizon

Time horizon, or your investment planning period, is just as important as risk and return are in making investment decisions. It varies from individual to individual and is one of the things that defines the mix of securities that you should invest in.

On the one hand, younger investors would typically have a long horizon; they would be more immune to short term fluctuations of risky investments like equities. Younger investors would also have less need for near-term income and would instead prefer to receive the fruits of their investments later in life. On the other hand, more mature investors like retirees would have a shorter horizon and would prefer less risky investments; these investors would also most probably look for investments that provide adequate periodic income like corporate bonds and other fixed-income securities.

4. Your attitude towards risk

What “kind of person” are you? Are you someone who cannot stand to go out unless you are covered by some kind of insurance policy? Are you someone who regularly buys lottery tickets? Are you a conservative poker player, waiting for at least a pocket pair of nines before you make a significant bet, or are you someone who goes all in as soon as you get flush outs on the flop? In other words, do you consider yourself risk-averse or risk-seeking?

In a previous post, we already defined investment risk as the possibility of losing money in an investment, or the possibility of earning less than what you expect. Risk-averse individuals would try to avoid this possibility as much as they can; the only way you can make a risk-averse individual take on risk is if you promise to provide “adequate” additional returns called risk premium. Risk-averse individuals would also even pay just to get out of a risky situation and get insurance, even if the insurance premium is greater than the “expected value” of the claim (the probability of getting into an accident times the value of the claim; since the probability than an individual will get into an accident is usually very small, the expected value of the claim is also usually just a small amount). Conversely, risk-seeking individuals would pay a certain amount to get into a risky situation; as long as there’s a possibility of earning big bucks, no matter how remote, these people seldom care about the very real possibility of a significant loss. For risk-seeking investors, the possibility of losing principal in investing in risky portfolios is acceptable, as long as there’s a chance of earning big rewards.

A retired investor is typically seen as a risk-averse investor since he neither has the time nor the earning power to make up for possible losses. In contrast, a younger, aggressive entrepreneur who has sufficient sources of income and many years to recoup losses may be described as risk-seeking.

Traditional financial and economic theory assumes that investors, in general, are risk averse; this assumption is the basis of the assumed positive correlation between risk and return. But when I ask my students if they think they are risk-averse or risk-seeking, quite a number of them declare with enthusiasm that they are risk seekers. Why do you think this happens? It’s because some of us often mistake risk aversion for cowardice, and interpret risk-seeking behavior as a sign of courage or (pardon my French) balls. We must remember, though, that more often than not, risk-aversion is just another form of common sense, and risk seeking is not risk taking but just a glorified and macho-fied version of being an idiot and not knowing any better.

Click here for Part 1.

Related Posts Plugin for WordPress, Blogger...