Becoming a Wise Investor — Part 2 of 3

Remember that childhood admonition before you cross a street — stop, look, and listen? It is much the same for investing. As you pause, look both ways, and listen for warning sounds, you can then step carefully into that busy street. Here are the first of nine questions to ask yourself before you cross Investment Street, Anytown, USA.

#1-Purpose

What am I trying to accomplish? If you were to tell me you’d like to invest X amount of money, my first question would be “why”? If you are simply trying to “make more money,” you might be tempted to throw money at anything that looks good and sounds great. If, however, you begin with clearly defined goals in mind, it greatly narrows the choices to more appropriate and suitable solutions. I call this purpose allocation before asset allocation.

#2-Time

How much time do I have to make this investment work for me? A short-term (two years or less) investment decision will look entirely different than a long-term goal of ten years or more. Research company, Dalbar, reported that stocks in the S&P 500 have generated an average annual total return of about 11% over the past several decades. During that same period, however, the average investor in U.S. stock funds earned just over 3.5%. Why? Think emotions! There have been two significant stock market corrections since 2000, both frightening and painful. If, during this time, you pulled out of stocks and sat on the sidelines waiting for the right time to get back in, you probably missed it. Time out of the market can be as great of a risk as staying in the market during tough times. Understanding your timeline plays a huge role in investment stamina — your ability to weather the ups and downs of the market cycles without letting emotions dictate your decisions.

#3-Risk

Do I understand my Risk Tolerance? Risk and return are closely correlated. The longer the time horizon, the more risk you can typically accept and more return you can generally expect. The shorter the time horizon, the more risk should be minimized and thus, less return should be expected. All investments have risk and you need to understand how much is appropriate based on your ability to weather volatile market cycles.

#4-Diversification

Am I appropriately diversified? This is a just another way of saying, “Don’t put all your eggs in one basket…or even two”. Ecclesiastes 11:2 says, “Divide your investments among many places, for you do not know what risks might lie ahead.” No matter how confident you are in a particular investment — no matter how many times someone promises it’s a sure thing–it’s not. Diversification can be among the most effective strategies for preserving and growing capital over time. It does not, however, guarantee a profit or protection from losses in declining markets. I apply the diversification principle in two ways:

The first involves dividing investments across multiple asset classes: stocks or bonds, for example. Stocks generally provide higher long-term returns but can also be very volatile. Bonds tend to be less volatile but produce lower returns. Alternative investments such as precious metals, real estate, or commodities can also add asset class diversification.

The second applies to the investment style. All strategies basically come down to two approaches, passive and active investing. The passive approach more or less follows a market index and generates the returns, good or bad, of that particular index. (Note, you cannot invest directly in an index). The active approach varies widely but has one common objective — to enhance returns and/or reduce risk.

#5-Due Diligence

Do I understand this investment choice? There’s no substitute for doing your homework. Media outlets tend to draw investors into the hype of investment ideas and ultimately, poor investment choices. Unfortunately, many lack basic financial literacy to help them discern the difference between good investment choices and inappropriate ones. I’ve seen investors, lured by enticing promises, overlook this very important step. And while we’re on this subject, please hear me: There is no such thing as a risk-free, high return, guaranteed investment! If it sounds too good to be true, stop and dig deeper. Prov. 14:5 says that “the naïve believe everything, but the sensible man considers his steps”.

Stop! Look! Listen! You’re almost ready to cross Investment Street…Part 3 coming next month…

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