Know your Investment Profile

Your investment profile

Define your investment profile by identifying:
1.  Your goals and constraints
2.  Your risk ability and tolerance
3.  Your cognitive biases and their impact on your emotions.


Profiling:  everyone is unique

Differences go beyond the level of wealth and stem from:

• 1.  Age
• 2.  Education
• 3.  Phase of life
• 4.  Profession
• 5.  ...

Financial situation as the core of your profile

1.  A very wealthy person with relatively little planned expenses

• Will be able to take considerable investment risk, as you have enough funds aside to absorb potential losses.
• Will be said to have a "high risk ability"

2.  A person with limited wealth and a large part of his assets reserved for financial commitments:

• Can only take limited investment risk, as he lacks funds to cover potential losses
• Will be said to have a "low risk ability"

Ranking the objectives is also key

1.  List your objectives and rank them by degree of priority:

• Saving for retirement
• Providing for children's education
• Purchasing real estate objects

2.  Risk tolerance will be:

• High for less important objectives
• Low for important objectives

Investment horizon:  the longer, the better!

1.  The longer the investment horizon, the higher the risk ability

• .... as investments may recover from potential losses

2.  The shorter the investment horizon, the lower the risk ability

• .....  as investments cannot recover from potential losses.

3.  Unless you want to speculate ... but at your own risk!

Cognitive biases and the 3 steps in investing

Cognitive biases affect investment decisions when:

1.  Defining the investment universe

• Choosing which asset classes / securities are taken into consideration

2.  Constructing the optimal investment strategy

• Forecasting expecting returns and risk

3.  Adjusting and rebalancing the portfolio.

Cognitive biases:  defining the investment universe

When defining the assets universe you want to invest in:

• You tend to over-invest in local companies (home bias)
• You tend to overweight recent information (recency bias)

You should get out of your comfort zone and do extensive research on securities which may not necessarily be close to your home, nor provide readily available information.

Cognitive biases:  constructing the portfolio

When making forecasts:

• You may be influenced by recent data, which may not be relevant (anchoring bias)
• You tend to be over-confident (overestimating expected returns and / or underestimating risk)
• You tend to look for evidence which will confirm our beliefs and ignore information that contradicts them (confirmation bias)

Look for the black swan!

Cognitive biases:  rebalancing

When rebalancing the portfolio:

• You tend to overestimate the value of assets you own and underestimate the value of (similar) assets you do not own (endowment effect)
• You tend to sell winning positions too soon and hold onto losing positions for too long (disposition effect)

The right question to ask yourself

For example:  

You bought 1000 Nokia shares at 30 EUR.  The stock goes to 60 .. and then drops to 20 EUR.  The question to ask yourself is:

"If I had 20,000 EUR today, would I purchase 1000 Nokia shares?"

• If you answer "yes", then keep the position.
• If you answer "no", then sell it.

Conclusions

Before constructing a portfolio, you need to define your

• Objectives
• Risk ability and tolerance

You should be aware that you are influenced by cognitive biases which may lead to sub-optimal investment decisions.

You should try to adjust as much as possible for these biases.