Jun. 12, 2009
What is the single most important factor that drives your financial success? You may think it is the right pick of stocks or the right timing (to invest when markets are rising and to pull the money out when markets are sinking). Wrong! The single most important decision is how you distribute your wealth across the various asset classes.
Typically, asset classes are stocks, bonds, cash, real estate, commodities and alternative investments. There are also other investments that may count as asset class, e.g. foreign currencies or luxury collectibles like art.
The crucial question is how to derive the right asset allocation for your portfolio from a basic understanding of asset classes. There is no one correct answer to this question. A lot depends on your personal and psychological factors. The easy part about this decision is that we know fairly well from past experience how different asset classes are likely to develop over the course of time. Nobody can forecast what the Dow will be like at the end of the year, or for that matter at the end of the next five-year period. But we know that, in the long run and despite considerable volatility, stocks will most likely have a positive return, which is much superior to other asset classes. We also know, for instance, that government bonds of developed countries will most likely be a safe bet in the short to mid-term outlook.
Analyse your investor personality
Years of interaction with wealthy investors have shown us that investors make one fatal mistake time and time again: They switch their financial personality at the most unfortunate point in time. During times of bullish markets they act like long-term investors with aggressive goals and during bearish market they change their personality and become extremely conservative investors. The disastrous fact is that this change from Dr. Jekyll to Mr. Hyde happens often enough near the bottom of the market (becoming conservative) or near the top (becoming bullish). A fatal pattern, which has diminished the wealth of many investors. This effect has also been described over and over again in behavioural finance research.
Research shows that the personality of an investor can be mapped along three dimensions and each of them has a major impact on your investment decisions:
Investment goals: This dimension relates to your overall goals in investing your assets: Performance goals, asset protection goals, income generation goals and so on. A conservative investor is focused on asset protection and income generation while the long-term investor is mainly interested in growing his assets over the long term. The balanced type is somewhere in the middle.
Risk tolerance: Your risk tolerance increases with the duration for which you can manage/endure the potential loss of a part (which could be a significant one) of your assets. The following factors determine your risk tolerance: age, time until retirement, your need to generate regular income from your assets, other sources of income, certain payments you have to make from your assets and so on. Basically, risk tolerance is determined by the circumstances of your life and your economic situation, and also by the level of risk you are willing to take for a return. These are mostly external, rational factors. A conservative investor is on an average closer to retirement and depends more heavily on cash flows from his assets. Therefore he has a lower risk tolerance than the long-term type.
Ability to cope with uncertainty: Whereas your risk tolerance is controlled by external factors your ability to cope with uncertainty relates to your psychology. Examples are trust, fear, sensitivity to bad news, insecurity about past decisions, the wish to have peace of mind etc. This is the area where behavioural psychology plays the biggest role. It is this part of an investor’s personality that can induce financial panics or out-of-control bull markets when vast numbers of investors react in similar manner, en masse. The conservative investor is not very trustful of financial markets. He feels highly uncertain about the volatility of markets and his peace of mind in financial matters is very important to him. On the other hand, the long-term investor would not get nervous by reading in his morning newspaper about a steep drop in the markets. Overall he is trustful that markets will eventually recover and is capable of moving on.
In Part 2 of this series we will describe how these dimensions come together to shape overall investor types and how different investor types should invest differently.