Pros And Cons of Growth Versus Value Investing

Courtesy :www.motifinvesting.com
 
How well do you know the differences between growth and value investing? Want to determine if one of these strategies is suitable for your investment goals? Let’s explore the principles of value and growth investing as well as the pros and cons of each of these renowned and debated investment strategies.
THE FUNDAMENTALS OF VALUE INVESTING
Studies have shown that value investing has done better over time compared to growth investing.But it should come as no surprise that exceptions can occur and under-valued companies aren’t always winners.
What’s the fundamental concept of value investing? The framework was formed in the 1930s by two finance professors at Columbia University, Benjamin Graham and David Dodd.
The basic idea is for investors to identify and purchase companies that the markets have undervalued. If and when the markets adjust upwards to the true valuation of those companies, value investors can earn profits on those price increases.
Cheap Prices Don’t Necessarily Indicate Good Value
Keep in mind, value investing isn’t about buying every stock that has fallen or is priced low. After all, low share prices can be due to legitimate reasons such as underlying issues with a company’s financial health and prices may remain low if solutions aren’t put in place.
Value investors look for companies with strong fundamentals that the market hasn’t fully reflected in the price. They analyze a company’s intrinsic value by looking at various aspects such as its cash flow, earnings, book value, and business model, looking for clues that the current stock price is undervaluing its full worth. A few guidelines that some value investors utilize to select investments include:
• D / E ratio < 1
• PEG ratio < 1
• Market Cap < Book Value
• Cash > Market Cap
• Current assets at least two times current liabilities
Now let’s take a look at some of the pros and cons of value investing.
Pros of Value Investing
• Value investors can take advantage of devalued assets when others are panicking.
• The hype and herd mentality do not have much of an effect on a value strategy.
• Day-to-day price fluctuations and market volatility are not much of a concern to value investors because they are focused on the value of a business instead of external factors.
• Value investors can experience steady and consistent gains that may outperform benchmarks such as the S&P 500.
Cons of Value Investing
• Value investors may lose out on larger returns due to searching for companies with a margin of safety.
• The under performance of a company’s share price could last for years or may never rise to the investor’s estimate of fair value.
• There may be a lack of liquidity due to the stock’s under performance or low market cap.
• It can be difficult to determine if a stock has bottomed out or could continue falling further down.
• Finding investments can require a lot of time spent on research and analysis.
THE BUILDING BLOCKS OF GROWTH INVESTING
Thomas Rowe Price, the founder of T. Rowe Price Associates, has been dubbed by many as “the father of growth investing.” Price’s growth philosophy was based on investing in companies that he believed would grow faster than the economy and inflation.
Some of the aspects Price looked for included well-paid employees coupled with low labor costs, limited competition, protection from government regulation, earnings per share growth, consistent high profit margins, and a minimum 10% return on invested capital.
Diamonds In The Rough
Growth investing is typically focused on a company’s potential down the road, and not so much on its current share price. Growth stocks also tend to be younger companies that reinvest their earnings into the company instead of paying dividends and are identified as growing significantly faster than their competition (aka Growth At A Responsible Price). They may also be a part of industries such as technology that are experiencing fast expansion.
Examples of guidelines that some growth investors follow when selecting investments include:
• Historic earnings growth. For example, a minimum of 7% earnings per share (EPS) growth for companies between $400M – $4B.
• Companies with an expected 10-12% earnings growth rate over the next five years.
• Industry leaders that have beat pre-tax profit margins for five years.
• Steady or rising ROE.
• Expectations that the stock price can double in five years.
Here are some noteworthy pros and cons of growth investing investors should consider:
Pros of Growth Investing
• Successful investments may appreciate much faster than the overall market by the very definition of growth investing.
• Investment selection is focused on attractive companies with above average earnings and sales growth.
• Investors can gain exposure to cutting edge industries that are rapidly evolving and are exciting to watch.
Cons of Growth Investing
• Higher risk and volatility.
• Dividends are uncommon as most growth companies reinvest their earnings.
• Time intensive to evaluate the credibility of various growth projection estimates.
• Valuations could be much higher than the market average to reflect projected growth that may never materialize.
Two Sides Of The Same Coin
If you don’t find yourself strongly preferring value investing to growth or vice versa, the good news is you don’t have to choose one over the other. Some investors choose to diversify and apply both methods to their portfolio’s stock selection.
Warren Buffet is known for not associating with one specific strategy and stated in his 1992 Chairman’s letter, “…the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?“.

Source: New feed

Pros And Cons of Growth Versus Value Investing

Courtesy :www.motifinvesting.com
 
How well do you know the differences between growth and value investing? Want to determine if one of these strategies is suitable for your investment goals? Let’s explore the principles of value and growth investing as well as the pros and cons of each of these renowned and debated investment strategies.
THE FUNDAMENTALS OF VALUE INVESTING
Studies have shown that value investing has done better over time compared to growth investing.But it should come as no surprise that exceptions can occur and under-valued companies aren’t always winners.
What’s the fundamental concept of value investing? The framework was formed in the 1930s by two finance professors at Columbia University, Benjamin Graham and David Dodd.
The basic idea is for investors to identify and purchase companies that the markets have undervalued. If and when the markets adjust upwards to the true valuation of those companies, value investors can earn profits on those price increases.
Cheap Prices Don’t Necessarily Indicate Good Value
Keep in mind, value investing isn’t about buying every stock that has fallen or is priced low. After all, low share prices can be due to legitimate reasons such as underlying issues with a company’s financial health and prices may remain low if solutions aren’t put in place.
Value investors look for companies with strong fundamentals that the market hasn’t fully reflected in the price. They analyze a company’s intrinsic value by looking at various aspects such as its cash flow, earnings, book value, and business model, looking for clues that the current stock price is undervaluing its full worth. A few guidelines that some value investors utilize to select investments include:
• D / E ratio < 1
• PEG ratio < 1
• Market Cap < Book Value
• Cash > Market Cap
• Current assets at least two times current liabilities
Now let’s take a look at some of the pros and cons of value investing.
Pros of Value Investing
• Value investors can take advantage of devalued assets when others are panicking.
• The hype and herd mentality do not have much of an effect on a value strategy.
• Day-to-day price fluctuations and market volatility are not much of a concern to value investors because they are focused on the value of a business instead of external factors.
• Value investors can experience steady and consistent gains that may outperform benchmarks such as the S&P 500.
Cons of Value Investing
• Value investors may lose out on larger returns due to searching for companies with a margin of safety.
• The under performance of a company’s share price could last for years or may never rise to the investor’s estimate of fair value.
• There may be a lack of liquidity due to the stock’s under performance or low market cap.
• It can be difficult to determine if a stock has bottomed out or could continue falling further down.
• Finding investments can require a lot of time spent on research and analysis.
THE BUILDING BLOCKS OF GROWTH INVESTING
Thomas Rowe Price, the founder of T. Rowe Price Associates, has been dubbed by many as “the father of growth investing.” Price’s growth philosophy was based on investing in companies that he believed would grow faster than the economy and inflation.
Some of the aspects Price looked for included well-paid employees coupled with low labor costs, limited competition, protection from government regulation, earnings per share growth, consistent high profit margins, and a minimum 10% return on invested capital.
Diamonds In The Rough
Growth investing is typically focused on a company’s potential down the road, and not so much on its current share price. Growth stocks also tend to be younger companies that reinvest their earnings into the company instead of paying dividends and are identified as growing significantly faster than their competition (aka Growth At A Responsible Price). They may also be a part of industries such as technology that are experiencing fast expansion.
Examples of guidelines that some growth investors follow when selecting investments include:
• Historic earnings growth. For example, a minimum of 7% earnings per share (EPS) growth for companies between $400M – $4B.
• Companies with an expected 10-12% earnings growth rate over the next five years.
• Industry leaders that have beat pre-tax profit margins for five years.
• Steady or rising ROE.
• Expectations that the stock price can double in five years.
Here are some noteworthy pros and cons of growth investing investors should consider:
Pros of Growth Investing
• Successful investments may appreciate much faster than the overall market by the very definition of growth investing.
• Investment selection is focused on attractive companies with above average earnings and sales growth.
• Investors can gain exposure to cutting edge industries that are rapidly evolving and are exciting to watch.
Cons of Growth Investing
• Higher risk and volatility.
• Dividends are uncommon as most growth companies reinvest their earnings.
• Time intensive to evaluate the credibility of various growth projection estimates.
• Valuations could be much higher than the market average to reflect projected growth that may never materialize.
Two Sides Of The Same Coin
If you don’t find yourself strongly preferring value investing to growth or vice versa, the good news is you don’t have to choose one over the other. Some investors choose to diversify and apply both methods to their portfolio’s stock selection.
Warren Buffet is known for not associating with one specific strategy and stated in his 1992 Chairman’s letter, “…the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?“.

Source: New feed

9 Mistakes First-Time Investors Make


    Courtesy : .thestreet.com

Investing in the stock market is no easy game. Many enter with high hopes, only to find themselves crushed and broke after a few months of trading. That is the harsh reality for would-be investors who do  not exercise caution, and who do not strive to find knowledge and understanding before they pump their money into the first “hot” share.
There is money to be made in the stock market, but competition is strong and fierce, and experienced traders have been learning the tricks of the trade for a long time. First-time stock market investors often enter this strange world of numbers with false expectations and ideals that ultimately lead them towards common mistakes.
Those who are new to the world of the stock market would do well to learn from these errors before they find themselves astray. Here are nine mistakes that first-time stock market investors frequently make:

 1. Not Having A Plan
 
Successful stock market investors have a solid plan, and they stick to it. Newbie investors on the other hand tend to go in blind, like a boat without a compass, and therefore get lost and stranded at sea.
A personal investment plan helps you to map your goals and objectives, your entry and exit points, the amount of capital you will invest in a certain trade, any potential risks, the maximum amount you are willing to lose, and your plans to diversify your portfolio. With these details you will be able to invest with purpose, according to and against your own principles. New investors who make a plan may also struggle to stick to it, and change their course whenever the market dips, or whenever an investment doesn’t go exactly as they expected. Sticking to your plan will help you to navigate the stock market even when times are tough. Not having one can cause you to flail out and make emotional decisions that are detrimental to your aims

 2. Playing The Guessing Game
 
Playing the guessing game with your stock market investments is exactly the same as gambling. It is your ability to work with stock market data and other relevant channels of information that distinguishes the two.
A real investment is not made on speculation, or on the basis of a rumor that you heard, but on a valuable opportunity that you have researched, and which looks like it will pay enough long term profits to justify the risk.New stock market investors tend not to do their homework very well, or at all. You should never take a stab in the dark with the stock market; you may as well play roulette. Instead, try to gather and monitor enough data that you can start to make informed decisions about where you will invest your money.
 Do your homework, stick to the plan, and your investments just might pay off.

 3. Not Understanding Risk.
 
Every investment comes with a certain amount of risk. That is the nature of the stock market, and of all investments. Newcomers often don’t properly evaluate the risk of their investments, or their own tolerance to that risk. This can cause them to make flamboyant moves with serious life savings that quickly land them in the dump.
On the other side of the coin, risk aversion can create a psychology of scared money, in which the first time investor is frightened to take an opportunity that looks lucrative because they don’t want to risk the losses.
 
 There is a balance to be found, and it lies in knowing that every investment is a risk, and also in knowing the margins that you are willing to push.
There are safe bets out there; investment options that come with very little risk. One example is to purchase blue-chip stocks from a very well established company. There is always some risk involved, but you can be fairly confident that these stocks will rise, or that the company will pay dividends.
Investments in which you stand to gain more, generally (but not always) come with a higher amount of risk. New investors fail to think about what they stand to lose as well as what they stand to gain. Your risk tolerance will likely determine, at least to some extent, your style of investment.

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4. Not Knowing How Much Is Too Much.
 
If you are new to stock market investments, and you play with only money that you are willing to invest, then you at least only stand to lose what you can afford. The single most devastating error that a first time investor can make, is to play with money that they cannot afford to lose. This is a direct ticket to complete emotional turmoil, irrational decision making, and perhaps even financial destruction.Whatever you do, only play with money that is yours. Do not take out loans to invest in stocks, especially if you are a beginner. Don’t invest your own reserves. Even experienced investors keep a liquid asset stream.

 5. Short-Term Thinking.
 
Many new investors rush to make their first stock market investments. The stock market isn’t some sort of get-rich-quick playground.New investors often enter with high hopes for a steep and rapid profit, and they want to make it big with short-term investments. This makes for bad investment decisions at the best, and for many leads to nothing but a quick exit from the marketplace.More established investors have a totally different idea about what makes a short-term and a long-term investment. In their view, a long-term investment might be 20 or more years, and even when they consider an investment to be short-term they will probably be looking to stick with it for three-to-four years.
If you thought you were going to turn a quick profit in a few months then it is time to re frame your approach to time. Be in it for the long run, or don’t be in it at all. Investment is best seen as a process of long-term wealth accumulation.

6. Selling Out In A Panic.
 
If you do have a long term plan in place, and you understand that stock market movement is best understood over the course of years and not weeks and months, then you probably won’t be in much of a panic if stocks start to decline. Stocks rise and fall all of the time.
First-time investors, if they have a short-term attitude towards investments, or obsessively monitor their stocks for daily movement, can often get more than a mild case of hysteria if they spot a downward trend. This can cause them to sell out their position blindly, without properly considering whether or not they are likely to rise back up.Very short-term trends are not great indicators overall, and experienced investors may see opportunity for recovery. Whatever happens you shouldn’t panic. Now is the time to make wise, sober-minded decisions

 7. Failing to Cap Losses.
 
The opposite to selling out in a blind panic, but just as damaging when the tides are against you, is to hold on to a losing stock even when market indicators suggest that the share is unlikely to pick up again. Did you see the keyword there? “Market indicators.” This is what an experienced investor uses to decide whether a downward trend is just a temporary blip, or whether it is a long-term loser.
Experienced investors cap their losses, and move onto the next investment idea. When a share is depreciating, knowing when to cut your losses is essential.
  
 8. Failing to Diversify Investments.
 
This really is a huge mistake that a lot of first time investors tend to make. It is never clever to put all of your money in one investment, or even one type of investment. Markets can crash, and stocks for a single company can go down the drain. If your whole investment strategy revolves around one company, or even one industry, then a single movement could cause you huge trouble.
More savvy investors tend to diversify their investments across several industries and sectors, and have a portfolio that involves stocks in a variety of different companies.Investors who feel intimidated with the market can reduce their risk and increase their diversity by investing some of their money in mutual funds and index funds, as well as making their own choices in a diverse way. It is also useful to keep assets outside of the stock market; keep some money separate, and invest in hard assets such as gold to diversify even further.

 9. Investing In Alluring Stocks.
 
First-time investors, if they are not making their decisions based on the proper information and stock market data, often do so based on what looks like a good deal. The problem with this is, those which look good at first glance, are not often the most lucrative investment opportunities.
Many new investors think that a low stock price makes for a great opportunity, but this is not necessarily true. Value is key, not price. Sometimes high priced stocks offer a high potential for return, and low priced stocks can be worthless investments.

Following the herd is another mistake, and can lead new investors into paying too much for a “hot” stock that will not hold its value in the long term.

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Source: New feed

5 Characteristics of a Successful Stock Market Investor

 Courtesy :finweb.com

There is no doubt that some people simply are better at playing the role of a stock market investor than others. When talking about somebody who has successfully worked his way through investing in the stock market, it is never a matter of luck but rather certain personal characteristics that decide how successful they are. While the best investors seem born with all the right characteristics, it is possible to discover and implement them yourself. Believe it or not, much of what you need to know is just stock market investing basics.

Personal Preparation.

The key is to always have a plan when you invest. Before you do anything, you need to know when you will purchase stock and when you want to sell. Equally important is knowing what you will do should things go wrong. And most importantly, you always need to know what your ultimate goals are, and be sure that all your investment roads lead to that end.

Research

You should never invest in a company without knowing where it’s coming from, where it’s going, how their products stack up against competitors. It is also important to know how that particular market is doing in general. Ultimately, you are putting your faith in a company that will make you money over some period of time, but it does not have to be based on complete blind faith. Do your research, and make an informed investment.

Knowledge.

If you don’t know what the market is doing right now, you have no business investing in it. Everybody pretty much has the same information, but everybody interprets that information a little different, which is where some investors succeed where others fail. The key is to find information that is as unbiased as possible, and milk it for everything it is worth.

Be Emotion-less.

Using unbiased information is useless unless you are going to be equally unbiased. Do not allow  past exploits and failures get you down or hold you back. And, you cannot allow success to sway you either. Just because you made a decent bank on a particular investment from ten years ago, is no reason to continue putting up your money for them. It is also no reason to be getting headstrong and overly confident about your investment practices.

Be Realistic
 

You must also be realistic. No investor is going to strike it rich right away, and no investor is going to have a perfectly flawless track record. Understand that sooner or later, you’re going to lose a little money. But if you follow the first four steps of this guide, combined with a little common sense, you can minimize how much that loss is and go on to reap greater rewards.

These five basic principles should help you to get on the road to proper stock market investing and help you remember your focus.

Source: New feed

5 Characteristics of a Successful Stock Market Investor

 Courtesy :finweb.com

There is no doubt that some people simply are better at playing the role of a stock market investor than others. When talking about somebody who has successfully worked his way through investing in the stock market, it is never a matter of luck but rather certain personal characteristics that decide how successful they are. While the best investors seem born with all the right characteristics, it is possible to discover and implement them yourself. Believe it or not, much of what you need to know is just stock market investing basics.

Personal Preparation.

The key is to always have a plan when you invest. Before you do anything, you need to know when you will purchase stock and when you want to sell. Equally important is knowing what you will do should things go wrong. And most importantly, you always need to know what your ultimate goals are, and be sure that all your investment roads lead to that end.

Research

You should never invest in a company without knowing where it’s coming from, where it’s going, how their products stack up against competitors. It is also important to know how that particular market is doing in general. Ultimately, you are putting your faith in a company that will make you money over some period of time, but it does not have to be based on complete blind faith. Do your research, and make an informed investment.

Knowledge.

If you don’t know what the market is doing right now, you have no business investing in it. Everybody pretty much has the same information, but everybody interprets that information a little different, which is where some investors succeed where others fail. The key is to find information that is as unbiased as possible, and milk it for everything it is worth.

Be Emotion-less.

Using unbiased information is useless unless you are going to be equally unbiased. Do not allow  past exploits and failures get you down or hold you back. And, you cannot allow success to sway you either. Just because you made a decent bank on a particular investment from ten years ago, is no reason to continue putting up your money for them. It is also no reason to be getting headstrong and overly confident about your investment practices.

Be Realistic
 

You must also be realistic. No investor is going to strike it rich right away, and no investor is going to have a perfectly flawless track record. Understand that sooner or later, you’re going to lose a little money. But if you follow the first four steps of this guide, combined with a little common sense, you can minimize how much that loss is and go on to reap greater rewards.

These five basic principles should help you to get on the road to proper stock market investing and help you remember your focus.

Source: New feed

What Is Your Risk Tolerance?

Courtesy : Investopedia

Risk tolerance is a topic that is often discussed, but rarely defined. It is not unusual to read a trade recommendation discussing alternatives or options based on different risk tolerances. But how does an individual investor determine his or her risk tolerance? How can understanding this concept help investors in diversifying their portfolios? 

Risk Tolerance by Time frame


An often seen cliché is that of what we’ll refer to as “age-based” risk tolerance. It is conventional wisdom that a younger investor has a long-term time horizon in terms of the need for investments and can take more risk. Following this logic, an older individual has a short investment horizon, especially once that individual is retired, and would have low risk tolerance. While this may be true in general, there are certainly a number of other considerations that come into play. 

 
First, we need to consider investment. When will funds be needed? If the time horizon is relatively short, risk tolerance should shift to be more conservative. For long-term investments, there is room for more aggressive investing. 

Be careful, however, about blindly following conventional wisdom. For example, don’t think that just because you are 65 that you must shift everything to conservative investments, such as certificates of deposit or Treasury bills. While this may be appropriate for some, it may not be appropriate for all – such as for an individual who has enough to retire and live off of the interest of his or her investments without touching the principal. With today’s growing life expectancies and advancing medical science, the 65-year-old investor may still have a 20-year (or more) time horizon.

Risk Capital

Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined as liquid capital, or capital that can easily be converted into cash. Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.

Unfortunately, those with little to no net worth or with limited risk capital are often drawn to riskier investments like futures or options because of the lure of quick, easy and large profits. The problem with this is that when you are “trading with the rent” it is difficult to have your head in the game. Also, when too much risk is assumed with too little capital, a trader can be forced out of a position too early.

On the other hand, if an undercapitalized trader using limited or defined risk instruments (such as long options) “goes bust”, it may not take that trader long to recover. Contrast this with the high-net-worth trader who puts everything into one risky trade and loses – it will take this trader much longer to recover.

Understand Your Investment ObjectivesYour investment objectives must also be considered when calculating how much risk can be assumed. If you are saving for a child’s college education or your retirement, how much risk do you really want to take with those funds? Conversely, more risk could be taken if you are using true risk capital or disposable income to attempt to earn extra income.
Interestingly, some people seem quite alright with using retirement funds to trade higher-risk instruments. If you are doing this for the sole purpose of sheltering the trades from tax exposure, such as trading futures in an IRA, make sure you fully understand what you are doing. Such a strategy may be alright if you are experienced with trading futures, are using only a portion of your IRA funds for this purpose and are not risking your ability to retire on a single trade. 

However, if you are applying your entire IRA to futures, have little or no net worth and are just trying to avoid tax exposure for that “sure thing” trade, you need to rethink the notion of taking on this much risk. Futures already receive favorable capital gains treatment capital gains rates are lower than for regular income, and 60% of your gains in futures will be charged the lower of the two capital gains rates. With this in mind, why would a low net worth individual need to take that much risk with retirement funds? In other words, just because you can do something doesn’t always mean you should. 

Investment Experience

When it comes to determining your risk tolerance, your level of investing experience must also be considered. Are you new to investing and trading? Have you been doing this for some time but are branching into a new area, like selling options? It is prudent to begin new ventures with some degree of caution, and trading or investing is no different. Get some experience under your belt before committing too much capital. Always remember the old cliché and strive for “preservation of capital.” It only makes sense to take on the appropriate risk for your situation if the worst-case scenario will leave you able to live to fight another day. 

Careful Consideration of Risk Tolerance.

There are many things to consider when determining the answer to a seemingly simple question, “What is my risk tolerance?” The answer will vary based on your age, experience, net worth, risk capital and the actual investment or trade being considered. Once you have thought this through, you will be able to apply this knowledge to a balanced and diversified program of investing and trading.

Spreading your risk around, even if it is all high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. This comes back to preservation of capital.Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your trades. It is a complex process of analyzing your personal financial situation and balancing it against your goals and objectives. Ultimately, knowing you risk tolerance – and keeping to investments that fit within it – should keep you from complete financial ruin.

Source: New feed

What Is Your Risk Tolerance?

Courtesy : Investopedia

Risk tolerance is a topic that is often discussed, but rarely defined. It is not unusual to read a trade recommendation discussing alternatives or options based on different risk tolerances. But how does an individual investor determine his or her risk tolerance? How can understanding this concept help investors in diversifying their portfolios? 

Risk Tolerance by Time frame


An often seen cliché is that of what we’ll refer to as “age-based” risk tolerance. It is conventional wisdom that a younger investor has a long-term time horizon in terms of the need for investments and can take more risk. Following this logic, an older individual has a short investment horizon, especially once that individual is retired, and would have low risk tolerance. While this may be true in general, there are certainly a number of other considerations that come into play. 

 
First, we need to consider investment. When will funds be needed? If the time horizon is relatively short, risk tolerance should shift to be more conservative. For long-term investments, there is room for more aggressive investing. 

Be careful, however, about blindly following conventional wisdom. For example, don’t think that just because you are 65 that you must shift everything to conservative investments, such as certificates of deposit or Treasury bills. While this may be appropriate for some, it may not be appropriate for all – such as for an individual who has enough to retire and live off of the interest of his or her investments without touching the principal. With today’s growing life expectancies and advancing medical science, the 65-year-old investor may still have a 20-year (or more) time horizon.

Risk Capital

Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined as liquid capital, or capital that can easily be converted into cash. Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.

Unfortunately, those with little to no net worth or with limited risk capital are often drawn to riskier investments like futures or options because of the lure of quick, easy and large profits. The problem with this is that when you are “trading with the rent” it is difficult to have your head in the game. Also, when too much risk is assumed with too little capital, a trader can be forced out of a position too early.

On the other hand, if an undercapitalized trader using limited or defined risk instruments (such as long options) “goes bust”, it may not take that trader long to recover. Contrast this with the high-net-worth trader who puts everything into one risky trade and loses – it will take this trader much longer to recover.

Understand Your Investment ObjectivesYour investment objectives must also be considered when calculating how much risk can be assumed. If you are saving for a child’s college education or your retirement, how much risk do you really want to take with those funds? Conversely, more risk could be taken if you are using true risk capital or disposable income to attempt to earn extra income.
Interestingly, some people seem quite alright with using retirement funds to trade higher-risk instruments. If you are doing this for the sole purpose of sheltering the trades from tax exposure, such as trading futures in an IRA, make sure you fully understand what you are doing. Such a strategy may be alright if you are experienced with trading futures, are using only a portion of your IRA funds for this purpose and are not risking your ability to retire on a single trade. 

However, if you are applying your entire IRA to futures, have little or no net worth and are just trying to avoid tax exposure for that “sure thing” trade, you need to rethink the notion of taking on this much risk. Futures already receive favorable capital gains treatment capital gains rates are lower than for regular income, and 60% of your gains in futures will be charged the lower of the two capital gains rates. With this in mind, why would a low net worth individual need to take that much risk with retirement funds? In other words, just because you can do something doesn’t always mean you should. 

Investment Experience

When it comes to determining your risk tolerance, your level of investing experience must also be considered. Are you new to investing and trading? Have you been doing this for some time but are branching into a new area, like selling options? It is prudent to begin new ventures with some degree of caution, and trading or investing is no different. Get some experience under your belt before committing too much capital. Always remember the old cliché and strive for “preservation of capital.” It only makes sense to take on the appropriate risk for your situation if the worst-case scenario will leave you able to live to fight another day. 

Careful Consideration of Risk Tolerance.

There are many things to consider when determining the answer to a seemingly simple question, “What is my risk tolerance?” The answer will vary based on your age, experience, net worth, risk capital and the actual investment or trade being considered. Once you have thought this through, you will be able to apply this knowledge to a balanced and diversified program of investing and trading.

Spreading your risk around, even if it is all high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. This comes back to preservation of capital.Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your trades. It is a complex process of analyzing your personal financial situation and balancing it against your goals and objectives. Ultimately, knowing you risk tolerance – and keeping to investments that fit within it – should keep you from complete financial ruin.

Source: New feed