Investing can be daunting, especially for folks who are just beginning their investing careers. However, with the proper knowledge and approach, investing can be a great way to grow wealth and achieve financial freedom. This blog will discuss some basic concepts investors should understand when getting started.
Risk and Return
One of the most fundamental concepts in investing is the relationship between risk and return. In general, investments that carry a higher risk also have the potential for higher returns, while investments with lower risk have lower potential returns. This relationship can be illustrated on a foundational level by comparing stocks and bonds. When investors purchase a bond, they are lending the bond issuer money. Governments, such as the United States, can issue bonds, or companies like Apple, Inc, can issue them. Bonds are issued with several terms. The maturity date establishes the length of the loan. The coupon tells the investors how much interest the bonds will provide. The investor will collect the coupon payments until maturity. Thus the expected return of a bond is generally stable. When investors purchase a stock, they buy fractional ownership of the company that issued it. As a fractional company owner, investors are entitled to a portion of the corporation’s assets and profits equal to their ownership percentage. Therefore, stocks are forward-looking mechanisms. Their price represents the expected future value of the company. If a company’s products and services are in high demand, the stock price would appreciate substantially, offering investors theoretically unlimited growth. On the other hand, if the company is poorly managed and collapses, the stock price could drop to zero, leaving investors empty-handed.
As we can see in the chart above, over long periods of time, investing in Stocks usually provides more growth than investing in bonds. It’s important to note that risk and return are not always directly proportional, and there is no one-size-fits-all approach to finding the right balance between the two. When making investment decisions, investors should consider their risk tolerance, investment goals, and time horizon.
Diversification
Diversification is another crucial concept for investors to understand. It involves spreading your investments across multiple asset classes, sectors, and geographic regions to reduce risk. By diversifying your portfolio, you can minimize the impact of any single investment on your overall portfolio performance. For example, instead of investing all your money in one stock, you might invest in a mix of stocks, bonds, and alternatives to create a more resilient portfolio. In the first section, we illustrated the difference between the two major asset classes, stocks and bonds. Within each of these asset classes are a wide range of sub-asset classes.
US Stocks are identified based on their market capitalization, or the total value of all of a company’s shares of stock. Large-Cap companies have a market cap of $10 Billion or more—such as Apple, Walmart, and Johnson and Johnson. Mid-Cap stocks generally have a market cap in the range of $10 – $2 Billion, and Small-Cap stocks have a market cap of $2 Billion to $250 Million. On the other hand, international stocks tend to be grouped by region or based on the home country’s economy, either developed or emerging market economy.
Because Bonds are loans, the issuer’s credit rating is the most significant data point. Countries’ central banks issue sovereign bonds. These bonds are grouped into developed market or emerging market, similar to foreign stocks. Credit agencies rate both Governments and corporations. The ratings provide a framework for investors from high-quality Investment Grade AAA to High-Yield or Junk, anything below BBB rating. The lower the rating, the higher risk of default which is the worst possible outcome for bond investors. Issuers offer higher coupons to entice investors to buy their bonds. This higher interest rate comes with a higher risk of default.
Stocks and bonds from these sub-asset classes will respond differently to shifting market conditions. Diversified portfolios can help investors achieve a better balance of risk and return and increase their chances of achieving their investment goals over the long term.
The image above shows the performance of each asset class from 2021 – 2022. As you can see, no single asset class was always the best-performing or worst-performing in a given year. Therefore, investors want to allocate their investment dollars across multiple asset classes and build a diversified portfolio.
Asset Allocation
Asset allocation is the process of deciding how much of your portfolio to allocate to each asset class. This is another important concept in investing, as it can significantly impact your ability to achieve your financial goals. The correct asset allocation will depend on your investment goals, risk tolerance, and time horizon. At the most basic level, if you have a long-term investment horizon and are comfortable with higher levels of volatility, you may allocate a larger portion of your portfolio to stocks. On the other hand, if you have a shorter time horizon and you are not comfortable with volatility, you might allocate more of your portfolio to bonds or other fixed-income investments. As investors develop their strategy and deepen their understanding of investment choices, asset allocation can take various forms. Some investors allocate to countries or industries, while others may want to stick with broad-based indexes. More investment vehicles are being created as more investors enter the capital markets.
Investment Risk: A Closer Look
At the beginning of the blog, we examined the relationship between investment risk, often measured in volatility, and return, measured in the growth of investments. Within the broad concept of investment risk are three essential concepts: risk tolerance, risk composure, and risk capacity.
Risk Tolerance is an investor’s willingness to make investments in volatile assets. An investor with a high-risk tolerance would be comfortable investing in a 100% – 80% stock portfolio. An investor with a low-risk tolerance would likely be comfortable investing in a portfolio of 0% – 40% stocks. Risk tolerance is not a binary calculation. Different portfolios within a household can have different risk tolerance. When an investor’s circumstances change, their risk tolerance may also change. It is essential to revisit your risk tolerance periodically throughout your investing career.
Risk Composure is an investor’s willingness to maintain risk tolerance during market volatility and change. For example, a person new to investing may think they have a high-risk tolerance when they make their initial investment. However, suppose the market dynamics shift, and their portfolio suddenly experiences a drawdown of -20%. In that case, they may lose sleep, experience higher levels of financial anxiety and get to a point where they need to adjust their portfolio. While they may understand volatility’s relationship with growth, they are uncomfortable when it happens to their portfolio. This is an example of someone with low-risk composure. They should consider building an investment portfolio more aligned with their risk composure rather than their risk tolerance.
Risk Capacity is the ability and need to take on investment risk based on an individual’s financial goals and timeline. For example, a person with little savings and big financial goals must take on investment risk to achieve their goals. In the first section of this article, we read that the investments offering the highest levels of growth are generally the investments that also experience the highest levels of volatility. At the other end of the spectrum, a person who already has significant savings will not need to add a high percentage of volatile assets to their portfolio because they do not need as much future growth to achieve their goals.
Investor Behavior
Many investors’ worst enemy is themselves. The image above is a graphical representation of the power of sticking with your investment strategy. As we have discussed throughout this article, investments go up and down. As Morgan Housel discusses in his wonderful book Psychology of Money, volatility is the price of admissions for market returns.
Many investors exit markets or stop adding savings to investment accounts during periods of volatility. For people with a long time horizon, this can be detrimental to their long-term investment success. Investors should avoid making emotional decisions based on short-term market movements and instead focus on their long-term investment goals. By understanding your risk (volatility) preferences and maintaining a diversified portfolio, you can position yourself to weather market fluctuations and achieve your investment objectives over the long term.
In conclusion, investing can be a complex and challenging endeavor, but by understanding these basic concepts, investors can make more informed decisions and position themselves for long-term success. Remember always to do your research and consult with a financial advisor before making any investment decisions.