Oran Hall | Making deliberative investment decisions
I am bringing together much of what I have written about deciding to invest in past columns for the benefit of the many prospective and new investors who ask about how to invest.
It is important to recognise that investing is dynamic because the needs of investors change, as do the markets and the environment in which they operate.
Investment decisions form part of a slew of other decisions, many of which are not financial. But these decisions do affect each other. Factors that affect investment decisions include personal and family circumstances, finances and goals, values, experience, knowledge, the capacity to handle the risks and uncertainties inherent to investing, and the state of the markets and the economy.
The usefulness of a decision depends on the circumstances in which it is made. A wise decision for one person may be a bad decision for another.
A good decision for an individual at one time may be a bad decision at another time, but investors love to get the best returns generally. Many are fixated on a high return - in a short time at that - but the rate of return is not all. Further, there is no rule of thumb that applies to all people for people have different circumstances and different priorities.
An important place to start is investing in self by doing courses, attending seminars, reading financial and general material, listening to and watching the wide range of economic and financial programmes offered by the media, engaging in discussion with those who are well-informed, and investing in the areas in which personal interest is high. Being familiar with an area of investment before taking the plunge makes for a more comfortable entry.
Investing in self is empowering and facilitates independent decision-making, but being able to make independent decisions does not remove the need to consult investment advisers. The capacity to do so makes it easier to relate to the adviser.
Successful investing rests on creating a portfolio with many elements, which gives it balance, but there are relationships that must be recognised. Generally, high returns come with high risk, and safe investments - those with more certain returns - give low returns and lose value in real terms over time.
Risk is unavoidable in investing. The higher it is, the greater the potential return or potential loss. A critical question is, at what point is it worth taking more risk with the expectation of getting higher returns? The answer to this question includes financial and psychological, or comfort-level, factors.
There are too many investors who do not fully understand risk. Many describing themselves as low-risk investors express the desire to invest in the more risky instruments, like equities.
There is nothing wrong with having some of the more risky instruments in a low risk portfolio. It is a question of the proportion of such instruments in the portfolio and the level of risk of each instrument. There are equities, for example, which are more risky than others.In contrast, there are other investors who are so conservative their portfolios are destined to yield a low real return.
Ultimately, the willingness and ability to take risk may be influenced by family responsibilities, the need to save for essentials, financial and investment knowledge, experience, financial resources, and age, for example.
Diversification is the counter to risk. In a well-diversified portfolio, the risks specific to particular companies or sectors cancel out each other because of the contrasting responses to the same event. Diversification does not, however, eliminate market risk. When the stock market experiences a general decline, for instance, all stocks, including blue chips, tend to fall, though to varying degrees.
The downside of diversification is that it limits the potential for high returns, but this has to be balanced against the fact that it limits the potential for high losses.
Over-diversification is also harmful. It raises management issues because it requires more time. It also tends to dilute returns because too many losers may dilute the impact of the winners, or too little investment in what turn out to be winners limits the gains of that portion of the portfolio.
Liquidity - the ease of converting to cash and not being forced to discount the price to sell quickly - is also an important consideration in investing. Some assets are more liquid than others, but the liquidity of the same type of instrument may vary. Market conditions and price are two factors that contribute to this.
Time is important. Investors have to determine if they want a return in the short term or in the long term. This may have some bearing on the kind of return or income that can be derived. If capital appreciation is what is desirable, for example, a long-term posture is the best position to take.
Time is also a consideration when determining how a portfolio is to be managed. In situations in which the investor does not have the time required to manage a portfolio, a passive approach - discretionary fund management or unit trust - is best.
Be deliberate as you decide how to invest.
- Oran A. Hall, the principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. firstname.lastname@example.org.