Tame the investment genie

(Part 11)

Some investors will put their money in various investments that are fraught with risk. Had these investors been fully informed of these risks, they most certainly would not have gone forward. The main problem is that the majority of investors are not aware of all the various risks involved with most investment programmes.

Add to this, the fact that most investors have never completed a risk profile questionnaire. This type of fact finder will help you to determine how much risk you are willing to tolerate in order to achieve certain results. The more accurate you are in determining your true risk profile, the better investor you will be. Many times, these questionnaires will tell you or your financial advisor if you have the ability to hold on to your portfolio during tough times. This could also serve as a wake-up call to tone down your current portfolio before market volatility shakes you up so much that you end up selling in a down market. This phenomenon of panic selling has the ability of turning normal market fluctuation (volatility) into financial risk (the loss of principal).

Quantify your knowledge level
Many people feel that they have to know everything about every investment. This, of course, is simply impossible. You would be well served to limit your circle of enterprise to areas that you feel comfortable and knowledgeable navigating. Investing in the unfamiliar is a common mistake that investors make. You increase the likelihood of losses when you invest in the areas about which you lack good and reliable information. Investment advisors report on how common it is to see people investing in areas in which they lack knowledge. Physicians will insist on investing in real estate ventures which they know next to nothing about while ignoring the very drug companies of which they have detailed knowledge.

Perhaps this is simply the story of the grass always looking greener on the other side. Make sure you take time to research opportunities within your field of experience. Chances are that many great investment opportunities are waiting right there. Research the investments you are familiar with and find out as much as possible before you invest, not afterward. Make sure you water your own grass! Many successful investors stick to one or two types of investments. Perhaps they switch back and forth between Treasury bills and Government bonds depending on the outlook of interest rates. They are often able to generate returns in the double digits with little room for financial loss. These investors believe in keeping it simple. Other investors will focus on just one family of mutual funds, moving from one type of fund to another within the family of funds. Many times, they are able to increase their overall return by several additional percentage points each year. Compare this to the investor who simply stays with the same fund, year in and year out. Still other investors have found success simply by watching their employer’s stock within their profit sharing plan. When they see their company’s stock reaching a new high for no apparent reason, they sell in this market rally. Once the stock drops in price, they move back in at the low price after evaluating that the company is financially strong and on the right track. This strategy of buying one or more company stocks during that stock’s high point and selling during the low point is known as the rolling stock strategy. It is also known as “buy what you understand.” Through the informal network of coworkers and your own knowledge, you may be more tuned in to the future and prospects of your company than many stock analysts.

Know What You Own
Knowledge is power — if it is knowledge worth knowing and properly used. Knowing what you own is one of your best defenses to avoiding mistakes. This assumes you have evaluated what you own beforehand and made the tactical decision to proceed with your purchase based on your knowledge level and research. You should weigh the many pros and cons of making such a commitment to any investment before investing. Many retirees confuse gambling with investing. They will take a position in a company’s stock based on what they hear and not on what they know. Perhaps a favourable news story motivated them. This is very common and is nothing short of gambling. This still can produce favourable results, if the stock market continues to increase at a torrid pace and if somebody is willing to pay a higher price for your investment than what you paid for it. There are a lot of ifs, however. True investors know why they should buy a certain investment. They know if a company is being properly managed as well as other important aspects of a company’s business. Typically, they know who the company’s largest customers are, as well as who the company’s competitors are. They will have a firm grasp on the company’s marketing and business plan. In addition, they will be firmly familiar with the company’s financials. They will have evaluated the company’s debt level, profit margins, cashflow, and any pending actions against the company. They will know what a reasonable price might be for that company’s stock and when it may be overvalued.

Know Why You Own It
Purchasing stock in a company or buying in a particular mutual fund should only be done when you have answered the question, “Why do you want to own these shares?” A prudent investor will know what an investment is capable of and, in general terms, what this investment will achieve in the near future and, more importantly, in the long term. Will your investment provide a steady stream of dividend income or a steady steam of profits to be retained by the company for future growth? Is this company or fund situated to take advantage of our changing economy or to profit from the current improvements in technology that are being seen daily? What is this mutual fund investing in ? Am I being pigeon-holed into this investment?

As a current example, many retirees have purchased stocks in companies or funds  that specialise in real estate investments. They are typically given a very high cash dividend of over eight percent plus the prospects of capital appreciation. These stocks typically do very well during times of moderate to high inflation. These investors know why they have purchased these stocks. They are able to garner current income to live on as well as having an excellent inflation hedge against future price increases from the ravages of inflation. Other investors will purchase fixed annuities instead of time deposits  because they are targeting a different agenda. They want security of principal along with higher interest rates. Because they know that fixed annuities are also tax deferred until funds are withdrawn, they know that their money will grow much more quickly in most cases. Therefore, they know why they are buying these types of investments and the benefits that they are reaping. Many of today’s investors are jumping on the current trend of owning  mutual funds.  It could be that an individually-tailored portfolio may better suit their risk tolerance. Prudent investors will stop to analyse how they can take advantage of the technology boom in a safer and more reasonable manner. They may see that the safe money is to be made by owning the companies that supply the many start-up companies. They may decide that communication companies are a better choice because all of these new companies will need phone lines, fax lines, Internet lines, and other related equipment. Furthermore, they may see that communication companies will further benefit from the increased usage of this type of equipment.

As a business and, consequently, as an investor, it may be more prudent to focus on high-tech supply companies instead of high-tech companies. Take the case of Internet companies in the United States. Their goods have to be delivered. Often this favours companies such as United Parcel Service and Airborne Express instead of the actual Internet companies. The competition is simply too fierce among most Internet retailers. A compelling example: during the California Gold Rush, it was the stores and equipment suppliers that became rich, not the miners. The first part of this article was published in Business Day on June 19