Assess Your Risk Attitude

2018-10-04 02:29
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Questions To Ask Yourself Before You Invest:

Q: Why save and invest? It could be trading on short-term assets or investing for long-term growth (e.g. for retirement).

Q: Do I have excessive debt? If you are repaying a loan with a very high interest rate it may be worth settling payments before investing. The gains you make on investing may be less than the interest you are paying on your debt.

Q: Am I insured against the unexpected? Insurance cover will put you in a stronger position to invest as you are less likely to need instant access to your savings. Having cover for things like death, illness and damage to your property will help avoid large unforeseen payments.

Q: Do I have sufficient cash saving? You need cash deposits for at least 6-month living expense.

Q: Do I need financial advice? A qualified financial adviser can help you to identify realistic goals and design an investment plan that fits your goals. But if you have the time and the knowledge to effectively manage your >mutual fund portfolio, you may want to do-it-yourself online with lower cost and more convenience.

How to Invest Wisely Even with Small Amount of Money?

Investing isn’t just for the wealthy. Almost anyone can devote at least a little money to investments, keep close tabs on it, and wind up with more money than he or she started with. If you have a few thousand dollars or even a couple hundred you don’t need right away, here are some tips on how to make the most of it.

1.Save Regularly. Set aside as much as you can after receiving each paycheck for investing. Do this even if you can devote only a few dollars at first. Even $100 per week will add up over time. Try to cut your costs of living. Don’t deprive yourself of necessities, but try to cut out luxuries, anything you don’t have to have. Many millionaires in the world start with a frugal living when start accumulating wealth. Warren Buffett and Li Ka Shing are truly rich people who take their income and turn it into wealth by investing wisely, saving, and living frugally.
2.Educate Yourself Before Investing. You need to understand what investment options you have, how to read offering documents, how to analyze investment options (for valuations, financial strength, growth potential, risk factors etc), as well as where to find information.
3.Keep Your Costs of Investing Low. Strictly keep brokerage/ advisory fees and commissions to less than 2% of the amount being invested. Mutual fund is a good start to invest if you have a small amount of money. Some mutual fund companies will allow investors to start investing with as low as USD 500 or regular installment of HKD 1000. By pooling money from many investors, mutual fund investing offers diversification, where expenses are shared among investors and risks are spread over a range of investments.
4.Investment Discipline. It is important for investors to keep a long-term perspective and avoid knee-jerk reactions. Stick to a well-diversified investment plan (asset allocation) with risks tightly controlled. Rebalancing is a way to keep the investor disciplined.

What Kind of Investor Are You?

Having learned about the basic of investing and products, you need to know about your investment behavior before you start to invest. Logically, every investor is different, with different financial goals, risk tolerance level, personal situations and constraints.

Major factors that affect an investment behavior include your definition of risk and time horizons, understanding of market as well as fear and greed. Over the past few years, psychologists have discovered that investors appear to fall into ‘types’, and that knowing what ‘type’ of investor you are helps to match the investor to the appropriate investment product and often improve long-term returns. One special note is that an investor will not permanently classify in one investor category or behavioral types as we all change our trading style, market understanding, goals, etc. over time.

Two Common Models to Access Types of Investors

1.One of the most successful investor classification systems is the Bailard, Biehl and Kaiser or BB&K model which categorizes individual investors to 5 categories.

  • Individualist investor – these are do-it-yourself (DIY) kind of investors who make their own trading strategies and decisions with rational thinking and prudent investment research. These investors are often methodical, careful, balanced and analytical
  • Adventurer investor – these are confident go-for-it (can also be greedy) kind of investors who are strong-willed and ready to take every chance. They are noticeable with their high position sizing, trading in volatility and institutional investor like approach. These investors are often not afraid to invest in high risk investments and placing of bets.
  • Celebrity investor – these are investors who always look for the ‘hot’ play. They stay closely in touch with the latest fashionable investment strategies and news. Usually they do not have any clear cut position sizing or asset allocation strategies. They feel more comfortable by joining the crowd and afraid of being left behind. These investors are often trend followers where majority of investors belonged to this group.
  • Guardian investor – these are investors who try to guard their wealth rather than grow more wealth. These people are very anxious about their money, do not easily trust others, and always look for less risky investment options. These investors are often near retirement age and invest only the safest things. Broadly speaking, these are the conservative/ risk adverse investors.
  • Straight Arrow investor – these are average investors who have all or some characteristics of above investors. They tend not to have very strong opinions and are not keen to take immediate actions. These investors are often willing to listen to expert advice and to take on moderate risk.

2. Barnwell Two-Way Model

The Barnwell Two-Way Model is a deceptively simple model that classifies investors as either ‘passive’ or ‘active’.

Passive investors are characterized as individuals who have become wealthy passively – by inheriting, by a professional career, or by risking the money of others rather than their own money. To these investors security is more important than profit. The study finds that occupations like doctors, corporate executives, lawyers and accountants are more likely into this category because these individuals are less likely to have high financial resources at an early stage and once earning a decent wage, they are then more careful with their money.

Passive investors may think that an investment is riskier than it actually is, which may keep them out of potentially lucrative opportunities. Passive investors are also more likely to need the approval of others and are unlikely to take the first step into unknown investment territory by being a contrarian but rather stick to trend following strategies.

Active investors are those who work hard and have achieved significant wealth on their own. They are more likely to take risks in investing because they have previous experience of taking risks in their previous wealth creation. These individuals have a high-risk tolerance and less of a need for security. They also need to feel in control of their investments, often to the extent of becoming highly involved with the running of their investments or becoming overly involved with technicalities and often may actually be detrimental. Moreover, these individuals are more likely to be contrarian in their stock picking habits and have less need to be completely diversified. By being actively involved and in control, these investors feel they are reducing risk. Once they feel they are losing control of an investment situation, their risk tolerance reduces. The classes of occupation that are likely to be active investors include: small business owners who have developed their own businesses rather than inherited, entrepreneurs, and self-employed consultants.

In summary, profiling and typographies help individuals to become better investors by highlighting deficiencies in investment style and behavior or how an investor is interacting with the market. By knowing what types of investors you are also make it clearer for you to face up to your financial problems or why the investment choices are not performing as intended.

What’s your attitude to risk?

To help you learn which kind of investors you are, it’s good to start accessing your risk tolerance level. As an investor you are likely to see the value of your investments go down as well as up. Are you comfortable with that prospect? Higher risk may lead to higher returns. Lower risk investments may limit the potential to increase the value of your money. Remember, all investments involve risk. If you aren’t prepared to take any risks, investing is not for you.

Risk Profiling

Risk profiling test helps you access your willingness and capacity to take risk and identify your risk profile of as an investor. Capacity to take risk is completely different from willingness to take risk. Ability of an investor to take risk can be assessed from his/ her financial position, nature and time for the goal. An investor can be risk seeker, but his financial condition and obligations may not allow him/ her to take excessive risks.

A variety of risk profiling surveys is used to determine individual risk tolerance level and with such to determine the appropriate portfolio asset allocation. The two primary theories related to risk tolerance are 1) conventional economic theory, which views risk tolerance as the willingness to accept greater variation in outcomes, and 2) prospect theory, which assumes investors place a greater weight on losses than gains. In such, a risk profiling survey generally accesses an investor’s financial situation, spending pattern, education and knowledge, investment experience, investment horizon, financial goals, investment response in times of crisis etc.

1) The economic concept of risk tolerance is an analysis of the willingness to accept variation in spending over time. Nobel Prize winners, Modigliani and Brumberg (1954), who developed the life-cycle theory of consumption, stated that individuals who are risk averse will prefer a smoother consumption path to variation in consumption during their lives. Preference for stable consumption leads investors to prefer assets with more certain payout and less volatility. This insight is fundamental in Modern Portfolio Theory (Markowitz 1952), which states that more volatile assets are valued less by investors who are risk averse. Individuals with greater levels of risk aversion require a greater risk premium before investing in riskier assets.

2) The prospect theory states that people make decisions based on the potential value of losses and gains rather than the expected final outcome. Some studies suggest that losses are twice as powerful, psychologically, as gains. Risk tolerance in the capital asset pricing model (CAPM) assumes that the capital market places greater value on assets with lower variance in returns.

Risk Profile Determination: Very Aggressive / Aggressive / Moderate / Conservative

Very Aggressive Investor: An investor of this risk profile seeks aggressive capital appreciation, and is willing to take a high level of investment risk. The investor typically possesses good knowledge of investment products, has investment experience, and is prepared to take capital loss should market situations turn adverse. Such an investor may invest additional monies in a market downturn to capture speculative short-term profiteering opportunities. The investments tend to overweigh in equities, emerging markets and/or small companies.

Aggressive Investor: An investor of this risk profile aims to achieve significant capital appreciation, and is willing to invest for a long horizon. The investor has good knowledge of investment products and accepts a higher level of investment risk for higher long-term investment returns. The investor is prepared to take capital loss on investments. The investments tend to overweight in equities, emerging markets and/or small companies.

Moderate Investor: An investor of this risk profile seeks capital appreciation, and is willing to invest for a long horizon. The investor has fair knowledge of investment products and accepts investment risk for long-term investment returns. The investor is prepared to take capital loss on investments. The investments tend to be more balanced on equities and bonds, and geographically more diversified.

Conservative Investor: An investor of this risk profile seeks investment returns above inflation rates (to preserve purchasing power) and is willing to invest for a medium horizon of 1-5 years. The investor accepts small volatilities in the value of investments. The investor is prepared to bear some capital loss but would like to keep such capital loss to a minimum. The investments are likely to be diversified and overweigh on income and yield-generating products such as bonds.

Changing Risk Tolerance

Whether risk tolerance will change over time? The preponderance of evidence suggests that risk preferences are relatively stable. Sahm (2007) finds that 73 percent of the systematic variation in measured risk tolerance is associated with things that do not change over time. Roskowski and Davey (2010) find a relatively small decline in risk tolerance before and after the global financial crisis of 2008. However, Sahm also finds that an improvement in macroeconomic conditions is associated with an increase in risk tolerance and that our willingness to accept investment volatility declines in old age. Financial decision making requires both memory and problem-solving skills and appears to decline significantly in advanced age (Finke, Howe, and Huston 2011). Given the evidence that risk tolerance changes in different economic situation and ages, we recommend reassessing your risk tolerance on an annually

Designing Your Investment Plan:

If you are ready to make an investment, here are some questions you might like to ask yourself.

1. Investment Objective –
Q: What do you want from your investment? It could be

  • Regular Income Stream
  • Balanced Between Income and Growth
  • Capital Growth

How long do you intend to stay invested?

  • Short-term (less than 2 years); Medium term (2 – 5 years); Longer term (over 5 years)
  • This will influence what types of investments you invest in and how much risk you can tolerate. The shorter the investment horizon, the less risky and more liquidity are your investment choices.

Q: Do you want to invest a lump-sum or by a regular monthly amount?

2.Investment Restrictions

Q: Any asset class or investment vehicle is prohibited from inclusion in your portfolio?

  • Normally individual investors have fewer investment restrictions than institutional investors such as Pension Fund. However, some investors may prefer to invest in social responsible companies while others invest according to their religious beliefs such as the Islamic funds.

3.Evaluating Performance/ Benchmarking

Q: How to evaluate your investment performance?

  • Choosing the right mix of investments (Asset Allocation) is just the beginning of your work as an investor. As time goes by, you’ll need to monitor the performance of these mutual funds to see how they are working together in your portfolio to help you achieve your goals. Lack of an objective monitoring is why some investors are likely to sell at market bottoms and sit on the sidelines as markets rebound.
  • To assess how well your investments are doing, make sure you compare apple to apple. Selecting an appropriate benchmark index to evaluate the performance of a mutual fund or your portfolio is one of the most important steps in performance evaluation. Benchmarking is simply the comparison of your investment with indices of same asset classes/ styles. For more sophisticated investors, Alpha and Beta are computed to figure out how their investments outperform/ underperform the benchmark.

Q: How often should you review your portfolio?

  • A portfolio review should be conducted periodically, often quarterly or annually to understand whether you are on course to meeting your goals. At the start of every calendar quarter or year is always a good time to take a look at your portfolio along with major economic data and earnings results released.

4.Rebalancing Discipline

Q: When and why to rebalance your portfolio

  • Over a period of time, some asset classes may provide higher returns than others while some give suboptimal results. In order to scale your portfolio to the right risk-return characteristics, your portfolio should be rebalanced periodically. Portfolio rebalancing is periodically resetting a mix of stocks and bonds by taking profits from outperforming investments and buying cheaper or undervalued ones. Therefore, rebalancing is also considered a contrarian strategy, objectively and effectively buy low and sell high, not only to restore the right mix of long-term asset allocation but also reduce portfolio volatility. For example, a contrarian investor would buy securities oversold by panic investors in down market while unloading overvalued assets at the same time, a way to enhancing long-term portfolio performance.
  • Having said that, there are costs associated with buying and selling mutual funds, so rebalancing too often can diminish the potential positive effects of doing it. The idea is to maintain your investment policies. Once-a-year is a sufficient frequency for rebalancing your mutual fund portfolio.

Rebalancing Example (Target asset allocation 50% stocks; 50% bonds)

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