Investing 101: Contradictions - Part 5

An important fact about investing is that there are no indisputable laws, nor is there one correct way to go about it. Furthermore, within the vast array of different investing styles and strategies, two opposite approaches may both be successful at the same time.

One explanation for the appearance of contradictions in investing is that economics and finance are social (or soft) sciences. In a hard science, like physics or chemistry, there are precise measurements and well-defined laws that can be replicated and demonstrated time and time again in experiments. In a social science, it's impossible to "prove" anything. People can develop theories and models of how the economy works, but they can't put an economy into a lab and perform experiments on it.

In fact, humans, the main subject of the study of the social sciences are unreliable and unpredictable by nature. Just as it is difficult for a psychologist to predict with 100% certainty how a single human mind will react to a particular circumstance, it is difficult for a financial analyst to predict with 100% certainty how the market (a large group of humans) will react to certain news about a company. Humans are emotional, and as much as we'd like to think we are rational, much of the time our actions prove otherwise.

Economists, academics, research analysts, fund managers and individual investors often have different and even conflicting theories about why the market works the way it does. Keep in mind that these theories are really nothing more than opinions. Some opinions might be better thought out than others, but at the end of the day, they are still just opinions.

Take the following example of how contradictions play out in the markets:

Kofi believes that the key to investing is to buy small companies that are poised to grow at extremely high rates. Kofi is therefore always watching for the newest and ambitious financial companies, which are just making some profits. Kofi doesn't mind because these companies have huge potential.

Akua isn't ready to go spending her hard-earned dollars on what she sees as an unproven concept. She likes to see firms that have a solid track record and she believes that the key to investing is to buy good companies that are selling at "cheap" prices. The ideal investment for Akua is a mature company that pays out a large dividend, which she feels has high-quality management that will continue to deliver excellent returns to shareholders year after year.

So, which investor is superior?

The answer is neither. Kofi and Akua have totally different investing strategies, but there is no reason why they can't both be successful. There are plenty of stable companies out there for Akua, just as there are always entrepreneurs creating new companies that would attract Kofi. The approaches I described here are those of the two most common investing strategies. In investing lingo, Kofi is a growth investor and Akau is a value investor.

Although these theories appear to contradict one another, each strategy has its merits and may have aspects that are suitable for certain investors. Your goal is to be informed enough to understand and analyze what you hear. Then you can decide which theories fit with your investing personality.



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Investing 101: Knowing Yourself - Part 4

Success depends on ensuring that your investment strategy fits your personal characteristics.Even though all investors are trying to make money, each one comes from a diverse background and has different needs. It follows that specific investing vehicles and methods are suitable for certain types of investors. Although there are many factors that determine which path is optimal for an investor, i'll look at three main categories: investment objectives, and investing personality.

Investment Objectives Generally speaking, investors have a few factors to consider when looking for the right place to park their money. Safety of capital, current income and capital appreciation are factors that should influence an investment decision and will depend on a person's age, stage/position in life and personal circumstances. A 75-year-old widow living off of her retirement portfolio is far more interested in preserving the value of investments than a 30-year-old business executive would be.

Because the widow needs income from her investments to survive, she cannot risk losing her investment. The young executive, on the other hand, has time on his or her side. As investment income isn't currently paying the bills, the executive can afford to be more aggressive in his or her investing strategies. An investor's financial position will also affect his or her objectives.

A multi-millionaire is obviously going to have much different goals than a newly married couple just starting out. For example, the millionaire, in an effort to increase his profit for the year, might have no problem putting down $100,000 in a speculative real estate investment. To him, a hundred grand is a small percentage of his overall worth. Meanwhile, the couple is concentrating on saving up for a family car and can't afford to risk losing their money in a speculative venture. Regardless of the potential returns of a risky investment, speculation is just not appropriate for the young couple. As a general rule, the shorter your time horizon, the more conservative you should be.

For instance, if you are investing primarily for retirement and you are still in your 20s, you still have plenty of time to make up for any losses you might incur along the way. At the same time, if you start when you are young, you don't have to put huge chunks of your paycheck away every month because you have the power of compounding on your side. On the other hand, if you are about to retire, it is very important that you either safeguard or increase the money you have accumulated. Because you will soon be accessing your investments, you don't want to expose all of your money to volatility - you don't want to risk losing your investment money in a market slump right before you need to start accessing your assets.

Personality
What's your style? Do you love fast cars, extreme sports and the thrill of a risk? Or do you prefer reading in your hammock while enjoying the calmness, stability and safety of your backyard? Peter Lynch, one of the greatest investors of all time, has said that the "key organ for investing is the stomach, not the brain". In other words, you need to know how much volatility you can stand to see in your investments. Figuring this out for yourself is far from an exact science; but there is some truth to an old investing maxim: you've taken on too much risk when you can't sleep at night because you are worrying about your investments.

Another personality trait that will determine your investing path is your desire to research investments. Some people love nothing more than digging into financial statements and crunching numbers. To others, the terms balance sheet, income statement and stock analysis sound like a Ghanaian trying to read Greek. Others just might not have the time to plow through prospectuses and financial statements.

Putting It All Together: Your Risk Tolerance
By now it is probably clear to you that the main thing determining what works best for an investor is his or her capacity to take on risk. I've mentioned some core factors that determine risk tolerance, but remember that every individual's situation is different and that what I've mentioned is far from a comprehensive list of the ways in which investors differ from one another.

The important point of this section is that an investment is not the same to all people. Keep this at the back of your mind for upcoming sections of this tutorial.



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