Monday, August 18, 2008

Another Look at Establishing Your Investment Goals

Establishing your investment goals in terms of risk, return, volatility, liquidity needs and investment term is crucial for succeeding in your investments and meeting your goals.

Before investing your money it is wise to determine the goals of your investment. We are usually quite good at setting the primary goal of investment – Better retirement, college fund, buying a house and more.

These end goals should be carefully examined and analyzed in order to adopt the most suitable investment strategy available. Therefore goals should be formalized and examined using the proper tools.

Setting goals for your investments should be based on two major parameters (excluding the initial sum of the investment which should be known by now):
  1. Risk and return (which always go hand in hand); and

  2. Term of investment

In setting long term investment goals planners usually have these two key parameters to toy with. The options are endless as the array of financial assets is never-ending and always growing but the basic sense and basic assumptions of financial planning stay the same:

  1. The higher the risk the higher the potential return on investment;

  2. Less known but very important – higher risk is assumed to yield a higher return in much better odds than 1:1 – each additional unit of risk is assumed to yield 1.x unites of return until a certain point where you need to take a lot more risk for each marginal return.

  3. The longer the investment term the more risk you can afford.

I’ve criticised these conventional rules of thumb in the past since each of us, as investors, face a certain specific scenario and not the average scenario where stocks yield 8% yearly, on average. It might well be the scenario we face won’t be so attractive. We, as investors, must take this possibility into account.

In setting investment goals you should ask yourself the following questions, after setting your goal:

#1 How much of my initial investment am I willing to lose and what is the return I expect on the risk taken?

Risk, simplified, is the chance of losing some or all of your initial investment or not gaining the required return on your investment. Risk and return go hand in hand. As the level of risk on the investment grows so does the expected return. This is obvious and intuitive. The higher the risk you are willing to take the bigger the stock component of your portfolio should be over bonds and deposits.

Risk is usually measured in volatility (standard deviation and variability). Higher volatility means a riskier asset with a much higher chance of losing some of the initial capital invested.

It is important to note that sometimes investing in a less risky portfolio doesn’t make much since. If the term of investment is long enough and we’re very far away from our goal it sometimes makes since to increase risk in order to increase the chances of actually meeting our goal at the end of the period. This ofcourse relies on the conventional financial planning wisdom where at the starting point of a very solid portfolio adding a bit more risk increases the chances of generating higher returns as per assumption 2 mentioned above.

#2 What is my investment term?

This question is of an utmost importance. Longer terms of investment allow for higher risk levels. Long investment terms have been empirically shown to smooth volatility over. I do recommend reading my post on why Long Term Investments are not Risk Free for my criticism on the matter. Diversification plays a key role here.

Are you a young student investing for over 10 years or are you approaching retirement with a shorter investment horizon? This should directly affect the risk levels you are willing to expose yourself to. The longer the term of investment the bigger the stock component of your portfolio should be over bonds and deposits. Long term investment in stocks is considered to be over 10 years.

#3 How much volatility can I tolerate? What is the level of liquidity I require?

As I’ve already mentioned, risk and return are often affected by volatility. High volatility is often the source of potential high returns. Your ability to tolerate volatility is mostly affected by your term of investment which is discussed above but is also affected by the chances of a financial surprise which will leave you wanting for cash. This is directly linked to the level of liquidity you require. Higher level of volatility tolerance and lower liquidity requirements allow for higher risk levels (Investing in stocks over bonds and deposits and vice versa as levels of volatility tolerance decrease).

Risk and volatility are highly connected. Conservative investors (which should allocate most of the investments to bonds and deposits) usually expose themselves to price deviations of up to 6%, more risky investors expose investments to price deviations of up to 10% and the riskiest go up to 15% and more.

After answering the questions above you can begin building a portfolio suitable for you.

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Images by: yuan2003

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