Investing Baby Steps #1: Know Who You Are
When we were just babies, we started to crawl in order to explore the “new world”. After a while, we noticed that there was more “out there” and we started to think about a way to go faster and further during our exploration. Then one magical day we decided to stand up on our 2 feet and look out at the horizon. In order to reach this point, we learned, step by step, how to walk. We fell a few times, we got hurt but our mommy was always there to take us in her arms and comfort us. Wouldn’t life be easier if our mom was still there to show us how to manage our personal finances as she was there to teach us how to walk?
Unfortunately, most parents don’t have much financial education (thx to the educational programs in our schools!) to pass on their children. We are literally thrown out of the nest like baby birds in the hopes that we learn how to fly before hitting the ground of a recession and get eaten by the Wall Street wolves waiting for us!
Managing a budget and paying off your debts is certainly very important. Yet, if you want to go forward financially, you should also supplement you revenues and build asset accounts by investing money. So once you have learned how to manage your budget and live within your means, it is time to start thinking about investing. This is why I am creating this investing baby steps series. Before you go read an investment guide and build a stock portfolio, you need to know who you are.
Investing Baby Steps #1: Know Who You Are
If you go meet a financial advisor, the very first thing he will talk about is your investor profile. They will give you a questionnaire (5 to 10 questions) and will determine which kind of investments is best for you according to your answers. The investor profile describes:
#1 Your Investment project:
Are you saving to buy a house?
Are you looking for a retirement plan?
Do you want to travel with this money?
Do you want to build a safety net for the darker days?
Depending on the project you chose, different investment strategies can be suggested. For example, if you think of buying a house in 3-5 years, you are better off investing most of your cash in fixed income such as bonds (70 to 80%) and the rest in the stock market. But, if you want to build a safety net and this amount needs to be accessible at all times, you are better off with money market funds or a high yield savings account such as Smartypig.
#2 Investment Horizon:
Do you plan to cash your investments in 1 to 2 years or in more than 10 years?
Knowing that market cycles (going from a valley to a peak and back to another drop in the market) last, on average, at least 5 years, investing your money in stocks with a time horizon of 3 years is like playing blackjack at the casino. You could almost double your money or lose 40% of it.
#3 Your risk tolerance:
Are you able to suffer a 10% market drop?
Do you panic when you start losing money on paper month after month?
Are you able to understand the difference between a short term fluctuation and your long term objective?
This is usually the last part of the questionnaire as the first 2 parts are pretty easy to determine and straight forward. However, determining your risk tolerance is a bit trickier. First, nobody likes to lose money. Second, everybody wants to take “risks” when the market goes up and wants to get out when the market goes down. Third, we are creatures often ruled by our emotions and our rationale disappears when we get our feelings hurt.
Since we often drive our investment decision based on fear, and fear is often driven by ignorance, I suggest you read more about personal finance and the economy in general. This is how you will understand that market drops like the one we experienced in 2008 happens regularly. The only difference with 2008 is that we got hit harder than usual, but investors suffered during the tech bubble as well. If we go back in time, we have gone through several painful experiences as investor. But we always survived and so did our investment portfolio!
So the very first step before starting to invest is to determine your investor profile. I would suggest you meet a financial advisor so he can help you understand the questions and provide additional information regarding the market. But don’t sign any investing papers besides your investor profile during the first meeting (of course, he will tempt you to invest right away ;-)). Take the time to fully understand what you want and what you are willing to go through in terms of market fluctuations before you start investing.
Next Thursday, we will look at different investment portfolios according to different investor profiles.
image source: polifemus