With the presence of various investment options, it is not enough that investors merely invest for the sake of “making a profit” or “gaining wealth”. Investors, first and foremost, must determine their specific investment objective before making any decision to invest.
Knowing one’s investment objective helps set income expectations and guides an investor about possible investment options. While all investment choices will attempt to earn a positive return, the level of risk affects potential income and actual generated returns will vary greatly depending on the chosen investment.
So before you venture into Setting your Investment Objective, let’s first understand your Risk Profile.
What is Risk Tolerance?
Not all people can handle high levels of risk. While some can take and accept erratic price fluctuations while trading the stock market, others prefer to invest in low-risk, low-return investments in order to preserve their capital.
The choice of risk should primarily depend on the investor’s level of reward expectations from an investment asset. Of course, the higher the expected reward, the bigger the risk the investor must take.
Risk could take the form of monetary loss, unguaranteed earnings, default of interest payment from the bond issuer, or anything that will not ensure the achievement of expected income or reward from the investment.
Overall, the level of risk can depend on a variety of factors including the individual’s level of investment knowledge, marital status, culture, and beliefs, but one’s age or phase in life could dramatically affect the level of risk the investor wishes to take. Here’s why.
How your Age affects your Risk Tolerance
There are three (3) basic life phases that people typically go through: Accumulation, Consolidation, and Spending phases. We explain all three in detail below.
1. Accumulation Phase
The accumulation phase usually applies to an investor in his 20s or early 30s. His net worth is probably fairly small and he might not have a lot of money, but he does have one useful commodity: time.
In the future, he might want to settle down, buy a house, buy a car, have children, send them to college, and then retire. He has a lot of plans for himself but he also has a lot of time to work to achieve these goals.
In general, people in the accumulation phase will be most interested in capital growth. As such, the investor is willing to make relatively high-risk investments — and with it comes the possibility of monetary loss — with the goal of growing money by achieving above-average returns.
2. Consolidation Phase
Once the investor reaches his mid-30s, he will likely move to the consolidation phase and stay there throughout the peak of his career until just before retirement.
During this stage, his loans and debts (including housing loan or car loan) should be nearly paid off and his children’s education expenses should be funded. In most instances, his earnings already exceed his regular expenses.
Retirement and estate planning are now his biggest concerns. People in the consolidation phase usually still have a decade or two to plan for these things. But since he knows he cannot continue working indefinitely and that he will soon rely on his savings and not on his salary anymore, his level of risk tolerance shifts from high to moderate. Capital preservation thus becomes a growing priority over the earlier investment objective of capital appreciation.
3. Spending Phase
As the investor approaches retirement, he enters the spending phase.
He has his daily living expenses covered, provided he is invested to receive a steady, stable income. He has no need to speculate aggressively and he knows the worst that can happen is to lose his entire savings. His biggest concern is inflation and how it eats into his own savings. It follows, then, that he is likely to become more risk-averse as he decides to place investments only in relatively low-risk assets that could beat inflation.
If the investor has earned a sizable savings and wealth, the spending phase might coincide with the Gifting phase, during which the investor will provide for friends and relatives or other people. During this phase, his primary goal shifts from capital growth to estate planning and tax minimization, while working on activities that he may find personally fulfilling or rewarding, such as charity work and philanthropy.
In the end, going through all these phases is ideal but may not necessarily apply to everyone. Some may go from consolidation to spending phase very quickly, while some may not have a lot of time to focus on spending phase. The phases we described above merely provide a guide and starting point for determining your own level of risk tolerance. Whatever your risk profile, it will typically be revealed to you when you start investing.
Now that you have identified your risk profile, it’s time to set your Investment Objective. Let’s proceed to Part 2 of this Investing 101 series: What’s your Investment Objective: Capital Appreciation, Preservation, Current Income, Total Return?
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