What money means to you? Answer 10 simple questions.

What money means to you? Answer 10 simple questions.

https://myinvestingnotes.blogspot.com/2010/01/what-money-means-to-you-answer-10.html

In order to really make your money work for you, it is important to try and get

• to know more about yourself and
• your relationship with money. 

Some "money psychology" should help you to deal with your financial affairs in a smart way.

To find out more about your investment orientation and your relationship with money, answer the 10 simple questions below as honestly as possible.  This will also help set the necessary guidelines for your investment portfolio.

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This is an excellent exercise for self-discovery and building a foundation for a sound financial plan. The questions below are designed to uncover your psychological drivers, risk tolerance, and core beliefs about money to help set guidelines for your investment portfolio.

Please answer these 10 questions as honestly as possible. There are no right or wrong answers.

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Your Money Psychology & Investment Orientation Test

1. The Primary Purpose: What is the primary role you want money to play in your life?

• a) Security and peace of mind (to eliminate financial anxiety).

• b) Freedom and flexibility (to make my own choices with my time).

• c) A tool for building wealth and achieving long-term, large-scale goals.

• d) A means to enjoy life's experiences and luxuries now.

2. The Windfall Reaction: If you received an unexpected $10,000 bonus today, your first instinct would be to:

• a) Immediately pay down debt or add it to your savings account.

• b) Spend it on a vacation, a nice gift, or an experience you've been wanting.

• c) Invest the entire amount in a diversified portfolio for the future.

• d) A mix: save some, spend some, and maybe invest a little.

3. Market Volatility Response: Imagine you invest $5,000, and over the next 3 months, the market drops 20%. Your portfolio is now worth $4,000. What is your most likely reaction?

• a) Panic. I would sell my investments to prevent further loss.

• b) Concern, but I would hold tight and wait for it to recover.

• c) Opportunity. I would consider investing more to "buy the dip."

• d) I would feel indifferent; I invest for the long term and expect these fluctuations.

4. The Time Horizon Lens: When you think about investing, what timeframe feels most comfortable to you?

• a) Short-term (1-3 years): I may need the money soon.

• b) Medium-term (3-7 years): For a major purchase like a house.

• c) Long-term (7+ years): This is for my retirement, which is far away.

• d) I don't have a specific goal; I just want to grow my money.

5. The Emotion of Spending: How do you typically feel after making a significant, unplanned purchase?

• a) Guilty and anxious, second-guessing my decision.

• b) Thrilled and satisfied, with no regrets.

• c) Neutral; I budget for flexibility and this was within my means.

• d) It depends entirely on what I bought and the value it brings.

6. Financial Role Models: Which statement best describes the financial lessons you learned growing up?

• a) "Money doesn't grow on trees." / "We have to be careful with our spending." (Scarcity Mindset)

• b) "It's important to enjoy what you earn." / "You can't take it with you." (Spending Mindset)

• c) "Save for a rainy day." / "Always have a safety net." (Security Mindset)

• d) "Make your money work for you." / "Invest in assets." (Wealth-Building Mindset)

7. The Risk Thermometer: On a scale of 1 to 5, how do you feel about potential investment risk?
- 1 - Loss Averse: The possibility of any loss is unacceptable. I prefer guaranteed, low returns.
- 2 - Cautious: I'm comfortable with very low risk for stable, modest growth.
- 3 - Balanced: I can accept moderate risk and occasional downturns for the chance of better returns.
- 4 - Growth-Oriented: I am willing to accept significant risk for the potential of high growth.
- 5 - Aggressive: I am comfortable with high risk and volatility for the possibility of maximum returns.

8. The Legacy Question: What best captures your long-term financial aspiration?

• a) To be completely debt-free, including my mortgage.

• b) To achieve financial independence, so work is a choice, not a necessity.

• c) To build substantial wealth that can be passed on to my family or charity.

• d) To have a comfortable life without financial stress, without necessarily being rich.

9. Information Digestibility: When it comes to managing your investments, you prefer to:

• a) Set it and forget it. I don't want to check my portfolio frequently.

• b) Receive regular summaries and only be alerted for major decisions.

• c) Be actively involved, researching and adjusting my portfolio regularly.

• d) Delegate the decisions to a trusted financial advisor.

10. The "Enough" Number: Financially, what does "success" look like for you in 10 years?
- a) Having no financial worries and a solid emergency fund.
- b) Being able to work because I want to, not because I have to.
- c) Seeing my investment portfolio consistently growing year after year.
- d) Living a life rich in experiences, funded by my investments.

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How to Use Your Results:

Once you've answered, review your choices. Look for patterns:

• Mostly A's: Your primary money motivation is Security. Your investment portfolio should be heavily weighted towards capital preservation (e.g., high-yield savings, bonds, conservative funds).

• Mostly B's: Your primary money motivation is Lifestyle & Freedom. You need a balanced portfolio that allows for both growth and liquidity for experiences, with an automatic savings plan to keep you on track.

• Mostly C's: Your primary money motivation is Wealth Building. You likely have a higher risk tolerance and a long-term focus. Your portfolio can lean more towards growth-oriented assets like stocks and equity funds.

• Mostly D's: You have a Pragmatic or Delegator style. You value simplicity and expert guidance. A diversified portfolio with a mix of assets or using robo-advisors/managed funds would suit you well.

This self-assessment provides a crucial "why" behind your financial decisions, allowing you to build a portfolio strategy that you can stick with emotionally and psychologically, not just mathematically.

Knowing yourself – Investment Objectives, Time Horizon and Risk Tolerance.

 Knowing yourself – Investment Objectives, Time Horizon and Risk Tolerance.

Elaboration of Section 2

This section acts as the crucial bridge between the theoretical philosophy of Section 1 and the practical strategies that follow. It argues that even the most brilliant investment strategy is doomed to fail if it does not align with who you are as an individual. Before you look at the market, you must look in the mirror.

The section breaks down this self-assessment into three core pillars, with a fourth critical factor underpinning them all:

1. Investment Objectives (The "Why")
This is the destination for your financial journey. What is the purpose of this money?

• Examples:

  • Capital Preservation: Simply protecting your initial capital from inflation (a primary concern for those in or near retirement).

  • Income Generation: Needing the portfolio to produce a regular, reliable cash flow (e.g., for living expenses in retirement).

  • Capital Growth: Aiming to increase the value of the portfolio significantly over time (common for younger investors saving for a distant goal).

  • Speculative Gain: Acknowledging a portion of funds for higher-risk opportunities (as mentioned in Section 1's Policy D).

• Why it matters: Your objective determines the types of assets you will buy. An income objective leads you to dividend stocks and bonds, while a growth objective leads you to growth stocks. A mismatched objective (e.g., using a speculative stock for capital preservation) is a recipe for disaster.

2. Time Horizon (The "When")
This is the length of time you expect to hold the investment before you need to liquidate it for your objective.

• Short-Term ( < 3 years): Money for a down payment, a car, or an emergency fund. This money has no business in the stock market due to its short-term volatility. It belongs in cash or fixed deposits.

• Medium-Term (3-10 years): Goals like children's education or a future business venture. Can tolerate some equity exposure but with a significant cushion of safer assets.

• Long-Term (10+ years): Retirement savings for a young person. This horizon can fully embrace the volatility of the stock market, as there is ample time to recover from downturns and benefit from compounding.

• Why it matters: Time is your greatest ally against risk. A long time horizon allows you to take on more short-term volatility (risk) in pursuit of higher long-term returns. A short time horizon forces you to be conservative to ensure the money is there when you need it.

3. Risk Tolerance (The "How Much Can You Stomach")
This is a psychological and emotional assessment of your ability to endure fluctuations in the value of your portfolio without panicking.

• Conservative/Low Tolerance: You lose sleep when your portfolio value drops. You prioritize peace of mind over high returns. You are likely a Defensive Investor.

• Aggressive/High Tolerance: You view market dips as buying opportunities. You can watch your portfolio decline significantly without feeling the urge to sell. You are likely an Enterprising Investor.

• Why it matters: The biggest enemy of investment returns is often our own behavior—selling in a panic during a crash. Knowing your risk tolerance helps you construct a portfolio you can stick with through market cycles. The provided link to a money questionnaire is a tool to help quantify this often-intangible feeling.

4. The Underpinning Factor: Financial Capacity & Cash Flow
The section wisely notes that your personal financial situation is the bedrock of everything.

• Financial Resources: How much money do you have to invest? A small investor may start with mutual funds for diversification, while a larger one can build a portfolio of individual stocks.

• Cash Flow Analysis: Understanding your income and expenses is critical. You should only invest money you do not need for living expenses and emergencies. Investing money you can't afford to lose or might need soon forces you into a short-term, high-pressure mindset, which is the antithesis of intelligent investing.

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Summary of Section 2

Section 2 emphasizes that successful investing is deeply personal and begins with a rigorous self-assessment of your Investment Objectives, Time Horizon, and Risk Tolerance, all supported by a clear understanding of your Financial Capacity.

• Investment Objectives define your financial goals (e.g., growth, income, preservation).

• Time Horizon (how long you can invest) determines how much market risk you can afford to take.

• Risk Tolerance (your emotional comfort with volatility) determines how much market risk you can personally handle.

By honestly answering these questions, you can create a personalized, "tailor-made" investment plan. This self-knowledge ensures you select strategies from Benjamin Graham's menu (Section 1) that you can stick with consistently, preventing the emotionally-driven mistakes that destroy wealth. In essence, this section ensures your portfolio is built for you, not just for the market.

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.

Cyclical losses from economic cycles, time horizon and retirement planning

The value of assets such as stocks and real estate increases on average over the long run.

It also tends to fluctuate in waves - it will go up for a while, then down a little, then up some more and down again.

If you are not careful these waves can make you seasick, metaphorically speaking, of course.

If you watch these cycles happen but aren't aware of how to manage your response, you could find yourself making poor financial decisions as a result or even attempting to retire shortly after a devastating economic collapse, as happened to many people after the 2008 financial collapse.

What are the ways to prevent this from happening?




YOUR TIME HORIZON AND ECONOMIC CYCLES

The main thing to consider is your time horizon - the number of years you have remaining before your planned retirement date.

When you are young and first begin saving for retirement, it is easy to take a lot of risk without worrying about CYCLICAL LOSSES, because you think you will have more than enough time to regain that value.

This is a mistake a lot of people make, as they sell all their investments when the economy crashes, forgetting that economies eventually recover.

A recession is the worst time to sell your investments because you will get the worst possible price for them, for the reason of a national economic cycle rather than anything inherent to the investments themselves.



DON'T CONFUSE ECONOMIC CYCLES WITH TROUBLED INVESTMENTS

It is important, however, that you don't confuse economic cycles with troubled investments.

If your investments are doing poorly in a strong economy, consistently underperform or otherwise give you a reason to believe that the price won't recover, then don't stay on a sinking ship - sell those investments and buy something better.

Losses resulting from economic cycles, such as recessions, will recover; so remain persistent.

After you get some practice and become familiar with these cycles, you can even sell your investments just as they begin and then rebuy them when they lose a lot of their value, maximizing your wealth.

Another approach is then to sell them again slowly as their price recovers.

This reduces some of the risk associated with the economy's uncertain movements - something which so many people struggle to predict, even experts.

If you know how to ride these cyclical waves in the economy, you can actually use them to your advantage, but even if you just hold onto your investments and wait out the recession, you will regain the value eventually.



FINANCIAL PLANNING NEARING RETIREMENT

These cycles only really pose a risk to people who are getting ready to retire in the middle of one.

This is why you should absolutely manage a shift in the types of investment you hold as you get closer to your retirement.

When you are young, more volatile investments like equity index funds will give you the highest growth rates, even though the price roller coaster may make you dizzy.

As you get closer to your retirement date, the timing of these cycles can be very unfortunate, leaving you with little money to fund your retirement; so over the years you should gradually switch from high-risk to low-risk investments.

This means that you should regularly increase the percentage of your total investments that are allocated to things like low-risk bonds, fixed-rate annuities or even high-yield bank accounts.

That way, by the time you are ready to retire, the fluctuations in the economy will have little influence on the value of your investments.

This process of gradual risk reduction will help to give you the highest returns on your investments, while carefully managing the amount of risk to which you are exposed.

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

Portfolio Management - Return Objectives and Investment Constraints

Return objectives can be divided into the following needs:

1. Capital Preservation - Capital preservation is the need to maintain capital. To accomplish this objective, the return objective should, at a minimum, be equal to the inflation rate. In other words, nominal rate of return would equal the inflation rate. With this objective, an investor simply wants to preserve his existing capital.

2. Capital Appreciation -Capital appreciation is the need to grow, rather than simply preserve, capital. To accomplish this objective, the return objective should be equal to a return that exceeds the expected inflation. With this objective, an investor's intention is to grow his existing capital base.
3. Current Income -Current income is the need to create income from the investor's capital base. With this objective, an investor needs to generate income from his investments. This is frequently seen with retired investors who no longer have income from work and need to generate income off of their investments to meet living expenses and other spending needs.

4. Total Return - Total return is the need to grow the capital base through both capital appreciation and reinvestment of that appreciation.

Investment ConstraintsWhen creating a policy statement, it is important to consider an investor's constraints. There are five types of constraints that need to be considered when creating a policy statement. They are as follows:

1. Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity, or cash. For example, within the next year, an investor needs $50,000 for the purchase of a new home. The $50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for the investor.
2. Time Horizon - A time horizon constraint develops a timeline of an investor's various financial needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long time horizon, the investor may have a greater ability to accept risk because he would have a longer time period to recoup any losses. This is unlike an investor with a shorter time horizon whose ability to accept risk may be lower because he would not have the ability to recoup any losses.
3. Tax Concerns - After-tax returns are the returns investors are focused on when creating an investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it may be important to focus on investments that would not make the investor's situation worse, like investing more heavily in tax-deferred investments.

4. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must be considered. An example of this would occur in a trust. A trust could require that no more than 10% of the trust be distributed each year. Legal and regulatory constraints such as this one often can't be changed and must not be overlooked.

5. Unique Circumstances - Any special needs or constraints not recognized in any of the constraints listed above would fall in this category. An example of a unique circumstance would be the constraint an investor might place on investing in any company that is not socially responsible, such as a tobacco company.

The Importance of Asset AllocationAsset Allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio. 

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more likely to have 80% in fixed income and 20% equities.
Citizens in other countries around the world would have different asset allocation strategies depending on the types and risks of securities available for placement in their portfolio. For example, a retiree located in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries, since the U.S. Government is considered to have an extremely low risk of default. On the other hand, a retiree in a country with political unrest would most likely have a large portion of their portfolio allocated to foreign treasury securities, such as that of the U.S.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/return-objectives-investment-constraints.asp#ixzz1yfCssLbg

Portfolio Management - The Portfolio Management Process

The portfolio management process is the process an investor takes to aid him in meeting his investment goals.

The procedure is as follows:

1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments.
2. Develop an Investment Strategy - This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions.
3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements.
4. Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan toadjust for the changes that have occurred.

Policy StatementA policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process.The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and ReturnReturn objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return. A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is important to consider not only return, but the risk of the investor in a policy statement.

Factors Affecting Risk ToleranceAn investor's risk tolerance can be affected by many factors:

• Age- an investor may have lower risk tolerance as they get older and financial constraints are more prevalent.
• Family situation - an investor may have higher income needs if they are supporting a child in college or an elderly relative.
• Wealth and income - an investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income.
• Psychological - an investor may simply have a lower tolerance for risk based on his personality.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/portfolio-management-process.asp#ixzz1yfBLNFTr

Top 10 Things to Do Before You Invest

Top 10 Things to Do Before You Invest
by Michele Cagan, CPA

1. Pay off every penny of credit card debt. You'll earn sky-high (18 to 22 percent!) returns just by paying your credit card balance in full rather than making the minimum monthly interest-laden payments.

2. Build yourself an emergency fund. Start a separate bank account for this purpose alone. It should have enough money to cover at least three to six months of living expenses.

3. Set up and follow a household budget. Keep track of where your money comes from and (even more important) where it's going.

4. Set clear financial goals. Whether you want to save for a new car this year or retirement twenty years from now, you need to know why you're investing.

5. Determine your time frame. How long your money will be working for you plays a key role in designing the best portfolio.

6. Know your risk tolerance. Investing can bring about as many downs as ups, and you have to know just how much uncertainty you can comfortably stand.

7. Figure out your asset allocation mix. Before you start investing, know what proportion of your portfolio will be dedicated to each asset class (like stocks, bonds, and cash, for example).

8. Improve your understanding of the markets. That includes learning about the big picture, such as the global political and economic forces that drive the markets and affect asset prices.

9. Set up your brokerage account. Whether you decide to start out with a financial advisor or take a more do-it-yourself approach, you'll need to have an open brokerage account before you can make your first trade.

10. Analyze every investment before you buy it. Buy only investments that you have researched and fully understand; never risk your money on an unknown.

http://www.netplaces.com/investing/planning-for-success/top-ten-things-to-do-before-you-invest-1.htm

Time horizon and Compounding ("Give me back my Youth!"

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

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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