Monday, March 28, 2011

6 Steps: A Guide for Newbie Investors (Part 2)

Here's a recap of the things we discussed in Part 1:

1. Eliminate and avoid excessive and expensive debt. Paying debt interest could significantly impair your capacity to accumulate capital for investment.

2. Build up your emergency fund. Maintain around 8 months worth of living expenses in liquid and stable instruments for unforeseeable financial needs.

3. Start investing. Invest in higher-yielding assets with manageable risk to to gain experience and be more comfortable with owning a portfolio that could lose value in the short term.

Once you have accumulated enough capital and investing experience, it's time to move on to the next three stages of a successful investing plan.

4. Invest more systematically

After establishing your initial investments, you can now invest on a more regular and deliberate basis. This means prioritizing what you set aside for investments by committing a set peso amount every pay day, for example. At this step, you can start investing in higher yielding securities like equity funds (e.g., equity UITFs, mutual funds, or index ETFs) and prepare for a longer-term investment horizon. People usually enter this stage in their 30s or 40s, particularly when they have achieved a more comfortable spread between their income and periodic expenses.

5. Invest in the long run

This next step is for investors who have set up a stable emergency fund and have already established a systematic investing plan. When you start making significantly more money than what you earmark for expenses and systematic investing, you can start investing strategically by managing your portfolio in such a way as to balance out losses with gains in other asset classes. In this stage you construct a diversified investment portfolio consisting of assets that are not perfectly correlated or do not perfectly move in the same direction. Perhaps the best illustration for this would be how bonds and stocks generally respond in opposite ways to different market shocks or conditions, as what we have been experiencing in the past few weeks with the events in the Middle East and the tragedy in Japan where stock prices have dropped considerably while bonds have become more expensive. You continue with the long-term investment horizon you started out with in the previous stage, and readjust the proportion of your holdings according on your risk aversion (i.e., more bonds if higher) and needs (i.e., typically more bonds as you get older).

6. Invest in speculative assets

This last stage is something I'm not very comfortable with since it's essentially just betting on something based on nothing more than a plain and simple guess, and it's something you only really learn with experience. Speculative investing covers strategies like stock picking and forex trading, and investments in assets like commodities, collectibles, and financial derivatives (like collateralized debt obligations and credit default swaps that have become infamous during the 2008 financial crisis), among other things. These strategies and investments feature a significant amount of risk but also the promise of very high returns which attract people who want to strike it rich quickly; some of these investors sometimes even use debt or leverage to boost the upside potential of their investments, which usually also amplifies risk to dangerous levels.

Because of the very high level of risk this step involves, many investors avoid it altogether. To end, in my opinion, you should only enter this stage if you're 100% comfortable with what you're doing and know all the risks that are involved; if not, just stick with step 5 and you'll still end up a highly successful and fulfilled investor.

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