When I first started dabbling in the stock market, I saw it as an interesting and exciting way to potentially make some big money. That was several years ago. Today, I still think it’s interesting and exciting, but I have given up any hope of making money. I’m joking ;). It’s possible to make some money if you take a wise approach.
In my early days in the markets, my approach was not wise. I downloaded the Robinhood app, deposited some money, and started buying stocks. I bought and sold stocks based on my “gut” feeling and whatever info I could find about a stock on Google. I didn’t lose a lot of money, but neither did I make a lot of money.
Don’t be like me when I made investment decisions based solely on gut feelings. Take a wiser approach. It starts with knowing something about stocks, the markets, and yourself as an investor.
Let’s start with knowing yourself as an investor. As an investor, you need to define your:
- Time horizon
- Risk tolerance
- Match for defensive or enterprising investing
- Investment philosophy
What are Your Goals as an Investor?
The most common investment goals are to “(1) accumulate funds for retirement, (2) save for a major purchase, (3) enhance current income, and (4) seek shelter from taxes.”1
Your goals will determine how aggressively you invest, what you invest in, and how long you invest. As an example, an investor who wants to enhance their current income might put most of their dollars in dividend stocks. Dividend stocks pay out a small amount of money, usually four times a year (quarterly), and these small payouts add up to increase an investor’s income. On the other hand, an investor who is seeking shelter from taxes would not go for dividend stocks because those payouts would be taxed.
Maybe none of those goals are your cup of tea. You want to make as much money as possible as fast as possible. That is possible to do but not without a lot of risk, luck, and skill. Don’t count on fast money.
What is Your Time Horizon?
Once you know your goals, you can determine your time horizon. How far in the future is your investment goal?
If you are a young person and want to start saving for retirement, you have a long time horizon. You don’t need your investment money tomorrow. You need it in 30 years. Why does this matter? With a long time horizon, you can be more aggressive with your investments. Being a more aggressive investor means putting a larger portion of your investing dollars into riskier investments. Why invest in riskier investments? Riskier means higher potential for reward (more dollars $$$).
There is a relationship between risk and reward. If an investor invests in a risky stock, he or she will want the potential for higher profits. Investors don’t take on risk for free; they want to be compensated for risk.
Example riskier investment: ARK Innovation ETF (ARKK)
There is more potential to lose money with riskier investments, but with a long time horizon it does not matter as much. Let’s say you buy several stocks, and their value drops a week later. It’s not as big of a deal because you don’t need the money tomorrow. There is still a lot of time for your investment to recover and grow. If the value of your investments has increased a fair amount when you need the money (in 30 years), you are in good shape.
A short time horizon would be something like investing your money to help buy a new Tesla next year. In this case, you need to put more of your investing dollars into safer investments. Why? Because you do not have as much time to recover from poorly performing investments. If you invest in the stock market to get your Tesla, and the market does poorly in the next year (say the whole market drops 10%), then you may not get that Tesla at the time that you want it. With a short time horizon, you need to focus on investments that protect the value of your original investment while providing smaller, but more certain gains.
Example safer investment: ProShares S&P 500 Dividend Aristocrats ETF (NOBL)
What is Your Risk Tolerance?
In investing, risk tolerance is about how comfortable you are with taking risks with your money. Can you keep your cool and rationally assess the situation if the value of one of your investments takes a nose-dive, or would you panic and immediately sell?
If you can keep your cool, then it’s likely that you have a higher risk tolerance. More aggressive investment in riskier assets may be more suitable for you.
On the other hand, if the thought of losing money in the stock market turns you into an anxious wreck, then it’s better if you stick to less risky investments.
Here’s a short discourse defining what I mean by risk:
The risk of an investment is measured by its volatility. Put simply, volatility describes the wideness of the possible range of an investment’s value. The wider the range of values, the higher the volatility of an investment. To get a little technical, a highly volatile stock might have a standard deviation of 20%, measured over a given time period. This means that in the future the value of the stock has a high chance of falling anywhere between losing 20% of its value and gaining 20% of its value. A lower volatility stock might have a standard deviation of 5%. It is likely to fall in the range of losing 5% or gaining 5%. It’s less volatile because the range of possible values is smaller. To the statisticians, forgive me if my explanation was not that great.
Professional investors use numbers like these, and they sound impressive and scientific. However, these predictions are not always that accurate. What do you need to know? A highly risky investment has a value that jumps all over the place. A very low risk investment has a value that is not likely to move very much.
Whether you have an appetite for volatility (risk) or are on the cautious side, you can still be a successful investor. You just have to find the style of investing that is comfortable for you and will allow you to reach your goals. Remember, though, that more risk usually means more reward, but that extra reward may not be worth it if you are developing ulcers due to anxiety. Think about how tolerant of risk you might be and let that help guide your investment decisions.
Nerdwallet offers a simple quiz to help you get a feel for your risk tolerance.
Defensive vs. Enterprising Investor
In the past, there was a famous investor named Benjamin Graham. He is known as the father of an investing style called value investing. In his famous book, “The Intelligent Investor,” Graham describes two different types of investors: (1) the defensive investor and (2) the enterprising investor.
In the words of Graham:
“In the past we have made a basic distinction between two kinds of investors to whom this book was addressed—the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.”2
If you want to invest but don’t have the time to put effort into researching stocks, then you’ll go the defensive route. Like Graham says, you want to avoid effort, annoyance, and the need for frequent decisions. In this case, put your dollars into an index fund and a bond fund and go your merry way. In fact, studies have shown that you’ll probably do better than most investors with this passive approach.
“I don’t want to be a defensive investor,” you say? Roll up your sleeves and get ready to burn the midnight oil. If you want to be an enterprising investor, you’ll have to put a lot of time and effort into first learning how to evaluate the quality of an investment, and then actually doing the work of evaluating investments. It’s not easy work, but like Graham says, there can be “worthwhile reward.”
Are you a defensive or enterprising investor? Either approach can be successful for building wealth, but you must find out whether defensive or enterprising investing is a better match for you given your personal characteristics and situation. It comes down to whether you are able or have the desire to put in the time and effort.
What is Your Investment Philosophy?
I’m not sure if he came up with the idea first, but I learned about investment philosophy from Aswath Damodaran, a prominent professor of finance. Every investor should have an investment philosophy.
Damodaran’s definition: “An investment philosophy is a coherent way of thinking about markets, how they work (and sometimes do not) and the types of mistakes that you believe consistently underlie investor behavior.”3
Put another way, an investment philosophy is a set of core beliefs about how the markets and investors function. It’s not something that you can develop overnight. It takes time and experience to find your investment philosophy.
Why do you need an investment philosophy? Our beliefs guide everything we do. If you don’t have a set of core beliefs about investing, then you will have nothing to guide your investment decisions. Investing without an investment philosophy is like handing darts to a blindfolded monkey and expecting him to hit the bullseye. Those darts can end up hurting someone. Likewise, investing without a solid framework for understanding the markets can end up hurting you. Damodaran gives three steps to finding your investment philosophy. I’ve added some of my own ideas to Damodaran’s ideas.
1. Acquire the tools of the trade.
Learn about the tools that investors use to evaluate a stock. Learn about technical analysis, fundamental analysis, macroeconomics, and microeconomics. Remember that a stock represents an underlying business. Look into how you might evaluate the qualitative aspects of a business. Does the business have a competitive advantage and a good management team?
2. Develop a point of view about how the markets work and where they might break down.
Understand the processes and techniques that investors use to make investment decisions (a lot of the things mentioned above). Think about where investors might make mistakes in the application of those processes and techniques. If you can find out where other investors have made mistakes in valuing a stock, you can potentially profit from their mistakes. Knowing something about behavioral finance might be helpful here.
3. Find the philosophy that provides the best fit for you, given your risk aversion, time horizon and other personal characteristics.
Investing success comes down to who you are as a person. Evaluate how your mind works, how your emotions work, your strengths, weaknesses, and personal situation. Then learn as much as you can about the markets and investing from books, blogs, YouTube, podcasts, and good, old-fashioned experience. Combine all that knowledge and experience with your personal characteristics to discover your investment philosophy.
After that, I would add a fourth step to Damodaran’s list. Once you have an investment philosophy, you can begin to develop investing strategies that are based on that philosophy. That said, strategies are a topic for another time.
I’ve only touched briefly on the topics covered. Some ideas I’ve only mentioned without explanation. If you have found an idea interesting, I encourage you to research it further. My hope is that I’ve aroused your curiosity about investing and given you a foundation from which to build. I don’t believe there is any one way to achieve success as an investor. Different ways work for different people. Whatever way you choose must fit your personal situation and characteristics. If your investment philosophy and strategies fit you as a person and help you to achieve your financial goals, then you are well on your way to investing success.
1. Billingsley, Gitman, and Joehnk, Personal Financial Planning (Cengage, 2021), 428.
2. Benjamin Graham, The Intelligent Investor (Harper Collins, 2009), Introduction, Kindle.
3. Aswath Damodaran, “Investment Philosophies: Introduction,” August, 25, 2014, video, 13:58, https://www.youtube.com/watch?v=CKuAStbkjuA&list=PLUkh9m2BorqlDJlnBXUaJaMRNE7UDckn6&index=2.
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