This statement would be considered to be an investment heresy by many financial planners and other investment professionals. Typically, the first thing that a financial planner will do is asses your “risk profile” when creating a financial plan for you. The problem with this approach is that it is almost impossible to determine your true investment ‘risk profile.’ Each person’s risk tolerance (risk profile) is very subjective and is a function of the environment in which they operate. The risk tolerance of most investors will be higher when they consider an investment that has increased significantly over the preceding months or years. As a result, these investors may decide to invest a significant portion of their capital in a very risky investment on the basis of its performance over the preceding period. This can have disastrous consequences for these investors when the investment begins to lose value.
People are continuously bombarded with information telling them about the state of the economy and markets, they are rarely in a position to make a calculated determination of their long-term investment strategy. Most investors are either too pessimistic in their perception of the investment markets or too upbeat - remember the term irrational exuberance? As a result, an investment strategy based on one’s “risk profile” may be completely incorrect as it does not relate to your current financial position or lifestyle objectives but rather to the prevailing emotional climate as influenced by short-term market fluctuations.
By basing your investment strategy on short-term, emotional thinking you will usually be incorrectly invested. For example, when the equity markets are in a slump, the average investor will be inclined to withdraw capital from these markets (at the bottom of the cycle) and invest in cash. When the equity markets recover, the same investor will not have sufficient exposure to equities and will miss the recovery. Conversely when equity markets are booming, the investor will have too much capital in equities and will therefore be overexposed when these markets fall; resulting in significantly higher losses than appropriate.
YOU NEED AN INVESTMENT STRATEGY
Too few individual investors adopt a proper risk management plan when making decisions about their investment capital. Risk management in this context means taking sufficient risk to achieve your investment objectives without taking more risk than is necessary. You can only adopt a proper risk management plan if you understand the risks of your current investments and the risks of any proposed future investments. By understanding the downside (risk) and the upside (growth) of each investment that you make, you are able to determine what investments would best suite your requirements. Risk management does not mean avoiding all investment risk as it would be impossible to achieve real growth (above inflation) without taking some investment risk.
An investment strategy that is based on your cash flow (lifestyle) requirements and financial position (current and future) enables you to determine at what rate your capital should appreciate in value. This level of growth must be measured against inflation. If you know that an investment’s potential growth is 10% per annum, you need to deduct the inflation rate (e.g. 6%) from this growth to quantify the real return of your investment i.e. 4%. If your required return above inflation is too high (anything over inflation plus 8% per annum) then you will have to take too much risk with your capital. You could invest a small portion of your capital in such an investment but you should not invest a large portion of your assets in such an investment.
It would be better to invest in a range of different asset classes to target a specific growth above inflation. If you have a defined asset allocation strategy, you can quantify the risk of your investment portfolio; this allows you to make more informed decisions about whether you are comfortable with the level of risk. This type of plan makes it possible to avoid the emotional roller coaster of investments. Emotion is one of the biggest causes of investment errors - both by private individuals and investment institutions. With a proper investment strategy you can reduce or even eliminate the impact of emotion on your investment decisions.