Would you like to invest, but you do not know what you need to do to increase the probability that you will be successful? If so, then the following general principles should be helpful.
1. Before you invest, make sure that you have . . .
- Sufficient insurance: disability, liability, life, medical, and property, and
- Enough emergency savings that you can get quickly if you need money in a hurry. Generally, the amount should be equal to at least two to six months of your after-tax income, depending primarily on how well covered you are by disability and medical insurance.
2. Determine your investment objectives before you make any investment commitments. Then, periodically make sure that your investments continue to conform to your objectives.
Larry Burkett, a Christian writer and lecturer on family financial matters, states on page 103 of his book entitled Investing for the Future,
There are many strategies for investing; no one of them is better or worse than the others. In great part the strategy you select depends on your goals, your age, your income, and your temperament. Each investor must consider all of these or the result will usually be turmoil, frustration, and financial loss.
Ron Blue, another Christian writer and lecturer on family financial matters, makes the following statements on pages 178-180 of his book entitled Master Your Money:
The best investment for any investor depends upon [his] personal long-term goals and the strategy to accomplish those goals.
From an investment standpoint, we have basically two time periods of life”: (1) the accumulation phase “when we are accumulating to meet long-term goals. . . .” and (2) the preservation phase “when we want to preserve the assets we have accumulated . . . .
You need to know [which phase you are in] because the investment techniques and the type of investment to be considered are different [for each phase].
3. Diversify your investments to the extent that your resources permit. Do not put all your eggs into one basket (i.e., only one type of investment). Be especially careful about investing too heavily in one company, especially if the company is your employer. Diversification helps to provide an appropriate balance to your investment portfolio, so you are not heavily exposed to circumstances that may have serious negative consequences for certain types of investments.
Consider, for example, an article in The Wall Street Journal (10-10-09), which stated,
Bonds have beaten stocks for as long as two decades – in the 20 years that ended . . . June 30 [2009] . . ., as well as 1989 through 2008.
[Y]ou can’t count on time alone to bail you out on your U.S. stocks. That is what bonds and foreign stocks and cash and real estate are for.
There are three primary ways to diversify investments.
Invest in several different types of investments, such as common stocks, bonds, and money-market instruments. The mix of different types of investments is called asset allocation and, according to an article in The Wall Street Journal (10-6-93), it is the most important decision that investors must make. The article went on to make the following statements:
[Y]ou should vary your mix of assets depending on how long you plan to invest. The further you are from your investment goal, the more you should have in stocks. The closer you get, the more you should lean toward bonds and money-market instruments. Bonds and money-market instruments may generate lower returns than stocks. But for those who need money in the near future, conservative investments make more sense, because there’s less chance of suffering a devastating short-term loss.
Generally, it is prudent to change your asset allocation as you get older or your financial circumstances change significantly. When people are relatively young, they have time on their side and, therefore, they can afford to be more aggressive, so they are likely to benefit longer term by investing a greater percentage of their financial assets in riskier types of investments, such as common stocks. Subsequently, as they approach their retirement years, it would be prudent for them to invest more conservatively.
In any case, you need to have some idea as to your tolerance for investment risk. A Wall Street Journal article (8-23-09) provided the following perspectives in this regard:
[H]ow can investors gauge their risk tolerance? To do so, they should take a number of factors into account, including age, income, savings, retirement plans, state of health and stomach for volatility.
Obviously, younger people can take on more risk as they have more time for compounding . . . and more time to make up for any losses.
Regardless of a person’s age, some degree of investment diversification is prudent, because every type of savings or investment has risk. Many people may think cash is an exception, but it isn’t. As the years pass, inflation will increasingly erode its value.
Another edition of The Wall Street Journal (9-21-03) had several other suggestions that may also be helpful in making diversification decisions regarding investment mix:
No matter what investment mix you own, you need to set targets for what percentage you will invest in each sector. . . .
[W]rite down why you are investing. Based on those goals and your appetite for risk, decide how you will divvy up your money between stocks and bonds.
[When you are feeling unnerved] go back and look at the percentages you settled on in calmer times. . . . [Y]our written targets will help bolster your resolve.
Every year or so, you should rebalance to bring your portfolio back into line with your target percentages. [Note: More frequent rebalancing may be advisable – perhaps, quarterly or when there are significant differences between the allocation percentages and the actual percentages.]
Invest in different types of industries, especially if you are investing in stocks. The circumstances faced by certain industries can change — for better or for worse — often before most investors are prepared to take appropriate action.
Invest in different maturities, if you are investing in interest- earning investments such as bonds and certificates of deposit, which have a maturity date. If all of your interest-earning investments mature about the same time, you are making a risky bet that future interest rate changes will not be unfavorable for you.
4. Take your time in making investment decisions. Do not rush into what initially seems to be a good investment, because further investigation may reveal that it isn’t. Luke 14:28 suggests that, before making a major financial decision, it is wise to give the matter sufficient thought.
5. Get all the knowledge you can before you make an investment. Seek information and ideas from qualified people and reliable sources of published information. By investing only in investments that you understand, even if this limits you to relatively simple investments, you will be following in the footsteps of Warren Buffett, who has been one of the most successful investors of all time. Also, you will be following the advice given in Proverbs 13:16a, which says, “Every prudent man acts with knowledge . . . .”
6. Consider your anxiety level before you make any commitments. Do not invest beyond the level of your own peace of mind. An article in The Wall Street Journal (1-23-98) made the following statements:
[B]e sure that you understand your tolerance for risk and that your portfolio is designed to match it.
Assessing your risk tolerance, however, can be tricky. You must consider not only how much risk you can afford to take but also how much risk you can stand to take.
Determining how much risk you can stand – your temperamental tolerance for risk – is . . . difficult. It isn’t quantifiable.
7. Weigh the degree of risk against the potential reward to determine if the degree of risk in making a particular investment is reasonable to you. The potential reward should be substantially greater than the potential risk.
Larry Burkett stated on page 28 of Investing for the Future,
Every investment carries some degree of risk. Just be very certain you know what the actual risk is, and decide if you’re willing and able to absorb it. Remember the counsel of Proverbs 27:12, “A prudent man sees evil and hides himself, the naïve proceed and pay the penalty.”
According to the last previously mentioned article in The Wall Street Journal, the risk that you can afford “depends mainly on your time horizon – how long before you will need the money.” Generally, the longer you have until you will need the money and the greater your other sources of income, the more risk you can afford. Keep in mind, however, that all investments — and even cash — have at least some type of risk. [Note: If you are interested in learning more about the different types of investment risks, please refer to the comments following this discussion of general principles.]
Perhaps you are wondering what the difference is between investing and speculating. Investing involves committing money in order to earn a financial return, whereas speculating involves incurring high risk in hope of obtaining a large gain (i.e., speculating is very much like gambling). While most investors can “win” over long periods of time, few speculators will “win.”
8. Invest for the long term. Avoid investing money that you cannot afford to commit for at least 10 years and, preferably, for 15-20 years. Securities markets fluctuate considerably, and even professional investors have difficulty attempting to deal correctly with these fluctuations. Do not expect to be able to consistently buy investments near their low price and sell them near their high price, since even professionals seldom can do this.
9. Be leery of promises of quick or extremely large returns from any investment. If an investment sounds too good to be true, it probably is, so take whatever time is needed to learn about an investment before you invest in it. Proverbs 21: 5 says, “The plans of the diligent lead surely to plenty, but those of everyone who is hasty, surely to poverty.”
10. Seriously consider selling an investment if it is not meeting your expectations, even if you have to sell it at a loss. You will not always be right when you purchase an investment, so do not expect all of your investments to be successful. Be willing to take the necessary action when you realize that you have made an error of judgment. Do not become blindly committed to an investment. Usually, successful investors retain their investments that are performing well and sell those that have continued to perform poorly.
11. Keep searching for good investments. Even if an investment that you have made has been performing well, consider whether it might be wise to sell it and invest the proceeds into an investment with better potential.
12. Deal only with established, reputable financial institutions. Do not invest through a brokerage firm or other financial institution unless you have checked its reputation.
For most people, no matter how well they follow the guidelines we have just discussed, the most important factor is how much they save. An article in The Wall Street Journal (6-18-06) said, “Your best investment strategy is saving. . . . If you want to be a successful investor, you first need to be a committed saver.”
Types of Investment Risks
When making investment decisions, it is important to be aware of the different types of investment risks. Each type of investment has its own risk characteristics. The following should provide you with a basic understanding of the five principal types of investment risk:
1. Business (credit) risk: The risk that a particular company’s earnings and/or dividends will not be satisfactory to meet at least the minimum expectations of the shareowners and/or creditors of the company.
2. Liquidity risk: The risk of sacrificing previously accumulated profits or income when converting an investment into cash.
3. Market risk: The risk that most, if not all, of the same type of investment will decline in price as a result of economic or political developments.
4. Purchasing power (inflation) risk: The risk that the return (i.e., appreciation and/or income) received on an investment will not keep pace with the rate of inflation.
5. Tax risk: The risk that changes in the tax laws or changes in interpretations of the tax laws will have a negative affect on an investment.
After you have determined your investment objectives, choose the investment alternatives that, when considered as a “package,” are likely to come the closest to enabling you to attain your investment objectives without exceeding the degree of risk with which you are comfortable for each type of risk. No single investment can provide every type of benefit for every investor. To obtain opportunities for higher returns, safety of principal generally must be sacrificed. And, to increase the certainty of continued income, it is usually necessary to accept a lower rate of income.
There are exceptions to the relative riskiness of the different types of investments. For example, many common stocks have been a more dependable source of income than some bonds. Also, risk within a particular investment category can vary considerably. This is particularly true for common stocks, since their growth potential, quality, and liquidity cover a broad range.
The right mix of investments can result in a substantially higher return than a somewhat different mix of investments that has the same degree of risk. An article in The Wall Street Journal (11-10-98) states, “[B]ased on returns over the past seven decades, a portfolio that is 23% stocks and 77% bonds has the same risk profile as an all-bond portfolio, but the expected return is almost two percentage points a year more.