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.

Investment Constraints

Liquidity

Liquidity refers to the ability to readily convert investments into cash at a price close to fair market value.

Investors may require ready cash to meet unexpected needs and could be forced to sell their assets at unfavourable terms if the investment plan does not consider their liquidity needs.

Time Horizon

Time horizon refers to the time period between putting funds into an investment and requiring them for use.  

A close relationship exists between an investor's time horizon, liquidity needs and ability to take risk.
The shorter the time horizon the harder it would be for an investor to overcome losses.

Tax Concerns

Tax concerns play a very important role in investment planning because, unlike tax-exempt investors, taxable investors are really only concerned with after-tax returns on their portfolios.

Legal and Regulatory Factors

Investors also need to be aware of legal and regulatory factors.

For example, some countries impose a limit on the proportion of equity securities in a pension fund's portfolio.

Unique Circumstances

There may be a number of individual and unusual considerations that affect investors.

For example, many investors may want to exclude certain investments from their portfolios based on personal or socially conscious reasons.

Here’s what Warren Buffett said how he got so rich

Here’s what Warren Buffett said when Tony Robbins asked him how he got so rich

NOV. 16, 2015, 1:30 AM

Billionaire Warren Buffett hasn’t always been as incredibly rich as he is today — in fact, 99% of his wealth was earned after his 50th birthday. Everyone has to start somewhere, even the wealthiest, most successful people.

The investing legend has been slowly building his fortune over the years, and today, the 85-year-old billionaire is one of the richest men in the world, with an estimated net worth of over $60 billion.

How did he come to earn such a mind-blowing amount of money?

Motivational speaker and author of “MONEY: Master The Game,” Tony Robbins, decided to ask him.

“I asked Warren Buffett — I said, ‘What made you the wealthiest man in the world?’” he tells entrepreneur and business coach Lewis Howes in an episode of his podcast,”The School of Greatness.”

“And he smiled at me and said, ‘Three things: Living in America for the great opportunities, having good genes so I lived a long time, and compound interest.”

Buffett has always been an advocate of keeping things simple and focusing on the long-term — that’s why he recommends low-cost index funds. 

One of the keys to Buffett’s wealth is simply time — 60 plus years of smart investing has allowed him to reap the benefits of compound interest.

Compound interest is when the interest earned on your investments earns interest itself — it’s what causes wealth to rapidly snowball, and in Buffett’s case, snowball to billions and billions of dollars.

Read more at http://www.businessinsider.my/how-warren-buffett-got-rich-2015-11/#S8a8PGvZDpxjKKZC.99

Don’t Let Your Losers Become Big Losers

Don’t Let Your Losers Become Big Losers

So with my Trailing Stop Strategy, when would I have gotten out of the failing muscle-shirt business? You already know the answer.

Remember, the shares started at $10 and fell immediately. Instead of waiting around until they fell to $6 as the business faltered, using my 25% Trailing Stop, I would have sold out at $7.50. And think of it this way – if the shares fall to $8, you’re only asking for a 25% gain to get back to where they started. But if the shares fell to $5, you’re asking for a dog of a stock to rise 100%. This only happens once in a blue moon – not good odds!

Take a look at how hard it is to get back to break even after a big loss...

You’ll Never Recover
Percent fall in share price	Percent gain required to get you back to even
10%	11%
20%	25%
25%	33%
50%	100%
75%	300%
90%	900%

So what’s so magical about the 25% number? Nothing in particular – it’s the discipline that matters. Many professional traders actually use much tighter stops.

Ultimately, the point is that you never want to be in the position where a stock has fallen by 50% or more. This means that stock has to rise by 100% or more just to get you back to where it was when you bought it. By using this Trailing Stop Strategy, chances are you’ll never be in this position again.

http://www.dailywealth.com/1041/Don-t-Lose-Money-The-Most-Important-Law-of-Lasting-Wealth

Redefining Investor Risk

by Troy Adkins 

You have probably been told by many financial advisors that your risk tolerance should be a function of your investment time horizon. This belief is touted by almost everyone in the financial services industry, because it is predominately accepted that if you plan to invest for a long period of time, you can make more risky investments. However, before blindly accepting this theory as factual truth, let's look at four ways in which risk can be defined. After thinking about risk from these four different perspectives, you may reach a different conclusion about investing. (Forget the clichés and uncover how much volatility you can really stand. To learn more, see Personalizing Risk Tolerance.)

Risk Theory No.1: Risk is Reduced if You Have More Time to Recoup Your Losses
Some people believe that if you have a long time horizon, you can take on more risk, because if something goes wrong with your investment, you will have time to recoup your losses. When risk is looked at in this manner, risk does indeed decrease as the time horizon increases. However, if you accept this definition of risk, it is recommended that you keep track of the loss on your investment, as well as the opportunity cost that you gave up by not investing in a risk free security. This is important because you need to know not only how long it will take you to recoup the loss on your investment, but also how long it will take you to recoup the loss associated with not investing in a product that can generate a guaranteed rate of return, such as a government bond.

Risk Theory No.2: A Longer Time Horizon Decreases Risk by Reducing the Standard Deviation of the Investment
You may have also heard that risk decreases as the time horizon increases, because the standard deviation of an investment's compounded average annual return decreases as the time horizon increases, due to mean reversions. This definition of risk is based on two important statistical theories. The first theory is known as the law of large numbers, which states that the likelihood of an investor's actual average return achieving its long run historical average return increases as the time horizon increases – basically, the larger the sample size, the more likely the average results are to occur. The second theory is the central limit theorem of probability theory, which states that as the sample size increases, which in this context means as the time horizon increases, the sampling distribution of sample means approaches that of a normal distribution.

You may have to ponder theses concepts for a period of time before you comprehend their implications about investing. However, the law of large numbers simply implies that the dispersion of returns around an investment's expected return will decrease as the time horizon increases. If this concept is true, then risk must also decrease as the time horizon increases, because in this case, dispersion, measured by variation around the mean, is the measure of risk. Moving one step further, the practical implications of the central limit theorem of probability theory stipulates that if an investment has a standard deviation of 20% for the one-year period, its volatility would be reduced to its expected value as time increases. As you can see from these examples, when the law of large numbers and the central limit theorem of probability theory are taken into account, risk, as measured by standard deviation, does indeed appear to decrease as the time horizon is lengthened.

Unfortunately, the application of these theories is not directly applicable in the investment world, because the law of large number requires too many years of investing before the theory would have any real world implications. Moreover, the central limit theorem of probability theory does not apply in this context because empirical evidence shows that a constant standard deviation is an inaccurate measure of investment risk, due to the fact that investment performance, is typically skewed and exhibits kurtosis. This in turn means that investment performance is not normally distributed, which in turn nullifies the central limit theorem of probability theory. In addition, investment performance is typically subject to heteroskedasticity, which in turn greatly hinders the usefulness of using standard deviation as a measure risk. Given these problems, one should not postulate that risk is reduced by time, at least not based on the premise of these two theories. (For more information on how statistics can help you invest, check out Stock Market Risk: Wagging The Tails.)

An additional problem occurs when investment risk is measured using standard deviation, as it is based on the position that you will make a one-time investment and hold that exact investment over the length of the time horizon. Given that most investors employ dollar-cost averaging strategies that entail ongoing periodic investment contributions, the theories do not apply. This is because every time a new investment contribution is made, that portion is subject to another standard deviation than the rest of that investment. In addition, most investors tend to use investment products such as mutual funds, and these types of products constantly change their underlying securities over time. As a result, the underlying concepts associated with these theories do not apply when investing.

Risk Theory No.3: Risk Increases as the Time Horizon Increases
If you define risk as the probability of having an ending value that is close to what you expect to have at a certain point in time, then risk actually does increase as the time horizon increases. This phenomenon is attributed to the fact that the magnitude of potential losses increases as the time horizon increases, and this relationship is properly captured when measuring risk by using continuously compounded total returns. Since most investors are concerned about the probability of having a certain amount of money at a certain period of time, given a specific portfolio allocation, it seems logical to measure risk in this manner.

Based on Monte Carlo simulation observational analysis, a greater dispersion in potential portfolio outcomes manifests itself as both the probability up and down movements built into the simulation increase, and as the time horizon lengthens. Monte Carlo simulation will generate this outcome because financial market returns are uncertain, and therefore the range of returns on either side of the median projected return can be magnified due to compounding multi year effects. Furthermore, a number of good years can quickly be wiped out by a bad year.

Risk Theory No.4: The Relationship Between Risk and Time from the Standpoint of Common Sense
Moving away from academic theory, common sense would suggest that the risk of any investment increases as the length of the time horizon increases simply because future events are hard to forecast. To prove this point, you can look at the list of companies that made up the Dow Jones Industrial Average back when it was formed in 1896. What you will find is that only one company that was part of the index in 1896 is still a component of the index today. That company is General Electric. The other companies have been bought out, broken up by the government, removed by the Dow Jones Index Committee or have gone out of business.

More current examples that support this empirical position are the recent demise of Lehman Brothers and Bear Sterns. Both of these companies were well established Wall Street banks, yet their operational and business risks ultimately led them into bankruptcy. Given these examples, one should surmise that time does not reduce the unsystematic risk associated with investing. (This company survived many financial crises in its long history. Find out what finally drove it to bankruptcy. Read Case Study: The Collapse of Lehman Brothers.)

Moving away from a historical view of the relationship between risk and time to a view that may help you understand the true relationship between risk and time, ask yourself two simple questions: First, "How much do you think an ounce of gold will cost at the end of this year?" Second, "How much do you think an ounce of gold will cost 30 years from now?" It should be obvious that there is much more risk in trying to accurately estimate how much gold will cost in the distant future, because there are a multitude of potential factors that may have a compounded impact on the price of gold over time.

Conclusion
Empirical examples such as these make a strong case that time does not reduce risk. Given this position, investors should reach a very important conclusion when looking at the relationship between risk and time from the standpoint of investing. You cannot reduce your risk by lengthening your time horizon. Therefore, the only way you can mitigate the impact of unsystematic risk, is by developing a broadly diversified portfolio.

by Troy Adkins (Contact Author | Biography)

Mr. Adkins is a senior investment analyst with a global tactical asset management firm. He works and resides in New York City. He has a diverse background and more than 10 years of investment experience.

Filed Under: Investing Basics, Investment

http://www.investopedia.com/articles/trading/10/investors-need-to-know-risk-time.asp

Understanding Risk And Time Horizon (video)

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Understanding Risk And Time Horizon

The interaction between your risks and your time horizon influ...

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The interaction between your risks and your time horizon influences every investment decision you make, whether you know it or not. Learn the basics here. Read: Redefining Investor Risk

You need a 100% gain to erase a 50% loss; averaging down will help you recover faster

You need a 100% gain to erase a 50% loss

Averaging down will help you recover faster

Jonathan Chevreau, Financial Post Published: Wednesday, September 16, 2009

After recoveries of 45% or more in major stock markets since the Crash of 2008, investors may well wonder how it is they're still not back to even.

Getty Images 

After recoveries of 45% or more in major stock markets since the Crash of 2008, investors may well wonder how it is they're still not back to even.

After recoveries of 45% or more in major stock markets since the Crash of 2008, investors may well wonder how it is they're still not back to even.

There are two reasons.

• One, broad markets are still below the highs reached before the crash. 
• Two, the arithmetic of loss means a 50% loss followed by a 50% rise does not mean you're back to even.

In the current edition of Graham Value Stocks, Norman Rothery notes the bellwether S&P500 index fell 57.7% peak to trough in the bear market, not counting dividends. It has since surged 53.1% from its lows but it still must rise another 54.4% to regain that former high. Thus, it would have to move 136.4% from the bottom reached after the original 57.7% loss, a result Rothery concedes may shock those unfamiliar with "the tyranny of losses."

The math is more understandable in absolute dollars. If you invest $100 at a top and lose 57.7%, you have just $42.30 at the bottom. But any gains you enjoy subsequently are coming off a lower base. Thus, even a 100% gain of $42.30 brings you only up to $84.60 -- still $15.40 less than the $100 you started with. To get back to $100, you'd need a 136.4% gain.

This is the ruthless arithmetic that has investors 100% in stocks -- or worse, leveraged so they were more than 100% in stocks -- licking their wounds in bear markets. However, B.C.-based financial planner Fred Kirby says ruthless arithmetic can be made to work to investors' benefit if dividends are reinvested during declines. This dramatically cuts the number of years needed to recover from losses.

Opportunistic buying can be combined with rebalancing of portfolios to maintain a normal ratio of stocks to bonds. Thus, after the 1929 crash, investors who reinvested dividends and regularly rebalanced recovered in seven years, compared to 22 years for all-stock investors who did not adopt this dual strategy.

Vancouver-based financial planner and author Diane Mc-Curdy says younger investors who dollar-cost averaged into the market early in 2009 have already done very well. Older investors should be conservative and adhere to the rule of thumb that fixed-income exposure should equal their age: so a 40-year old would be 60% stocks to 40% bonds.

The more you had in equities during the crash and the more those equities were in risky segments of the market, the worse the arithmetic of loss. Here, the accompanying chart adapted from Rothery's newsletter is instructive.

In peak-to-trough terms -- with the trough in March 2009 -- the hardest-hit market was the MSCI Emerging Markets index, which fell 67.4%. By early September, it was still 36.8% below its highs, despite the fact emerging markets bounced back 93.8% from their lows. They still must rise a further 58.1% to get back to their former highs. If you're in an emerging markets mutual fund or exchange-traded fund, you're still under water. Of course, if you were prescient enough to buy more at the bottom, you've almost doubled your money on that portion of your bottom-fishing adventure.

A glance at your portfolio may reveal that if you did do what the fund companies urged and "went global" some years back, you're probably still hurting most in funds that track the MSCI EAFE Index: Europe, Australia and the Far East. While the EAFE index didn't fall quite as hard as emerging markets -- it fell a nasty 63.5% -- at this point it still has "the largest hill to climb," Rothery says. EAFE markets are still 39.1% below their peak and have retraced only 66.9%, leaving almost as much again -- 64.2% -- before unitholders feel whole again.

Even the TSX composite still must rise 39.4% to get back to its former highs: something most people realize intuitively since the TSX passed 15,000 before the crash and is now just above 11,000.

Tomorrow, we'll look at what recourses investors may have to recoup losses.

jchevreau@nationalpost.com

Read more: http://www.financialpost.com/story.html?id=1998122#ixzz0eY9tf2po

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http://www.financialpost.com/story.html?id=1998122

Time Horizon

What are your major deadlines in life?

 How much time do you have to save and invest before you retire?

Your time horizon is very important when you invest, because compounding works best over a longer period. 

Time and risk are also related. 

If you are young and have many working years ahead of you, you can afford to take bigger risks with your investments than an older person close to retirement.

Be realistic: adjust your investment objectives to fit in with your time horizon and risk tolerance level.

You also have to realise that you need to align your time horizon, risk tolerance and investment objectives. 

You might have a very short time horizon before retirement and a low risk tolerance, you might want to see significant capital growth. 

It is important to be realistic:  you have to adjust your investment objectives to fit in with your time horizon and risk tolerance level.

This also means you will have to find a balance between the risk you are prepared to take and your preferred returns.  Risk and reward are always at opposite end of the scale - the higher the risk, the higher the potential return, and the lower the risk, the lower the expected return.

Therefore, the importance of you knowing more about who you are and how you want your money to work for you at this stage in your life. 

Three most important personal factors to consider: Your Time Horizon, Risk Tolerance and Investment Objectives

How well do you know yourself

In understanding your relationship with money, what are the 3 most important personal factors to consider?

These are:

1. how long or short a time you have to invest
2. how much risk you can tolerate, and,
3. your investment objectives and whether they fit in with your time horizon and risk appetite.

Cash flow is another important factor to keep in mind when you assess your personal situation.  You need to have a good idea of your cash inflows and outflows and of how to do a balancing act between the two.  That is why a cash-flow needs analysis is such an important part of any financial advice programme.

By knowing more about yourself and where you want to be, you can now use this knowledge to construct an investment portfolio that fits your unique needs: 

• your time horizon,
• your risk tolerance and
• investment objectives. 

In short, you have created an investment portfolio tailor-made, so that your money can work for you.


Related:
Understand what money means to you:  Answer 10 simple questions
http://spreadsheets.google.com/pub?key=tr9oMvjAsDJvkcPgXdd763A&output=html

Asset Allocation:  The Best Way to Minimize Risk of Your Portfolio
http://myinvestingnotes.blogspot.com/2011/01/asset-allocation-best-way-to-minimize.html

The Problem with Losses

The Problem with Losses

Big Losses

This investment has an expected return of 9.50%. Standard statistical thinking tells us if we invest in this stock and hold it, some years we will have high returns and some years low returns, but that, on average, the return will be 9.50%. This assumption is true, but it is also a potentially misleading result.

Suppose an investor buys this stock and holds it 10 years. In each of 9 of these years, the stock advances 20%; in the other year it falls 90%. The 10 year arithmetic average return is 9%
{=(9x20% - 90%)/10}, slightly below the return predicted by the distribution.

In reality, a $1000 investment, however, would be worth only $1,000(1.20^9)(0.10) = $516, less than the starting value! The compound annual rate of return is a negative 6.40%.

Learning points:

1. A large one-period loss can overwhelm a series of gains.
2. If an initial investment falls by 50%, for instance, it must gain 100% to return to its original value.
3. Big losses complicate actual returns, and investors learn to avoid situations where they may lurk.
   
   

Small Losses

Over time, even small losses can be a problem if too many of them occur.

An example will show why. Suppose the proverbial statistical marble jar contains two colors of marbles: red and green. The red marbles symbolize a 10% gain in the stock market, while the green marbles symbolize a 10% loss. If, in simulating an investment and taking a number of marbles from the jar, we draw exactly the same number of red and green marbles, how did the investment fare?

The return is negative, but there is no way to tell how badly things turned out, because what matters is not the proportion of winners to losers, but the number of losers.

As the number of draw increases, the terminal value of the investment declines.

After about 1,000 draws from the jar, the investment is nearly worthless. #

# In the stock market, such an investment could not survive. No security should have an expected return of zero. No one would buy it. Consequently, its price would fall until it offered a return consistent with its risk.

Learnng point:

Over time, even small losses can be a problem if too many of them occur.

Risk and the Time Horizon

There is an important distinction between:

• the probability of losing money and
• the amount of money that you might lose.

Suppose you model a $100 investment by flipping coins. Heads means you win $1, and tails means you lose 50 cents. After one flip, there is a 50% chance of a loss. This declines to 25% after two flips and is down to 12.5% after three flips. After 10 flips, the probability of a loss is only 0.10%.

The maximum loss, however, increases with each succeeding toss of the coin. The maximum loss after one flip is $0.50, after two flips is $1.00 and after three is $1.50.

If you define risk as the probability of losing money, then risk decreases as the time horizon increases.

However, if you define risk as the amount of money you might lose, it increases as the time horizon lengthens.

Learning points:

1. In general, the longer you hold a common stock investment, the lower the likelihood that you will lose money.
2. On the other hand, the longer you hold the investment, the greater the amount you might lose.
3. The extent of the risk depends on how you define it.