How to Create a Profit-Making Investment Philosophy - 4 Questions to Answer
As the evaluation of possible investments is often very tricky, each investor should create their own investment philosophy, which will be a consistent point of reference while making investment decisions. When we develop our own set of clear guidelines that will stand behind our investment philosophy, our decision-making process will be easier. The investment philosophy as a set of principles and guidelines will help you make critical decisions regarding investing. Before writing it down, try to define your objectives and core beliefs regarding financial markets.
Table of Contents
- 1. What is Your Goal as an investor?
- 2. What is Your Risk Tolerance?
- 3. What Type of Assets Would you Like to Buy?
- 4. How Much Time Do You Have?
- How to Choose the Best Investment Philosophy
- Types of Investment Philosophies
1. What is Your Goal as an investor?
Starting investing you should primarily determine your goal as an investor. This is the most important question because your whole investment philosophy will be based on the given answer. You should think about what you are trying to accomplish. To answer this question, you need to figure out what stage in life you are in. As it is usually connected with risk management, you can decide if you want to focus on your asset growth or asset protection.
What are your investment goals?
Is your objective to grow your wealth?
Is your objective to protect your wealth?
By answering these questions, you will state clearly your goals what will help you create an effective investment philosophy.Back to top
2. What is Your Risk Tolerance?
As risk tolerance is an important element of investing, you should determine realistically what degree of variability in investment returns you are able to withstand. By projecting your ability to put up with drastic slides in the value of your investments, you can include or exclude certain types of assets. However, it is better not to overestimate your risk tolerance because taking on too much risk may result in panic and eventually selling stocks at the wrong time. One of the risk tolerance factors is age. It is generally believed that younger people who perceive their investing process in the long term are more willing to take on greater risk, whereas older people with a shorter-term investment perspective have lower risk tolerance. Another factor that may influence risk tolerance is income. It is estimated that people with bigger disposable income and a higher net worth are more willing to accept greater risks than those with lower income. However, people are different and it is not possible to predict all human behaviors. Before creating your own investment philosophy, it is recommended to give some thought to your own risk tolerance regarding investing and answer the following questions:
How much risk are you going to accept?
Are you a risk-seeking or risk-averse investor?
Do you expect high or low rates of return?
Are you ready to sacrifice part of your capital for future returns?
Do you want to preserve your capital?
How would you feel if you lost everything?
What rates of return do you expect?
What is your investment time horizon?Back to top
3. What Type of Assets Would you Like to Buy?
When you decide to invest in financial markets, you need to remember that the risk is unavoidable. If your investment goal is to maximize the potential profits, you must accept an extremely high risk. Whereas playing safe will protect your assets and minimize risk. Having a clear view of your risk tolerance will help you determine what assets you want to buy. The rule of thumb is the higher risk, the higher returns. Since some investment classes are inherently risky, you need to make a thorough analysis and be aware of this risk to make a knowledgeable decision.
Generally, you can invest in the following asset classes:
- equities (stocks),
- fixed income (bonds),
- cash equivalent or money market instruments,
- savings accounts,
- real estate,
- derivatives (futures),
Each type of asset has a different risk/reward ratio. Investors buy and sell both tangible and intangible instruments to generate additional income on a short- or long-term basis. Generally, equities are considered to be the riskiest class of assets because gains are dependent on the successes and failures of privately held businesses. There is no guarantee an investor will get any return on investment, not to mention a situation of losing the whole initial capital.Back to top
4. How Much Time Do You Have?
Active investing requires a lot of time, so go over how much time you have to follow and participate in the markets. If you have a business or engaging career, it is improbable you will be tracking all financial data and all swings of markets on a daily basis. A realistic analysis of your disposable time may be a key factor while choosing your investment philosophy. If you are aware, you can’t devote enough attention to active trading, you can invest in well-managed funds. In some cases, time can be a decisive factor influencing your choice of investment philosophy.Back to top
How to Choose the Best Investment Philosophy
Answering questions from previous paragraphs should help you develop your investment philosophy and facilitate your future decision-making process. During high volatility times, sticking to your initial investment rules will help you make better decisions.
Professional investors usually develop their own investment philosophies and refine them over time. Even if market conditions change, they usually adhere to the principles which they have developed for years. So let’s look at types of investment philosophies.Back to top
Types of Investment Philosophies
To develop the right and successful type of investment philosophy, you should take into account your goals and needs, your time horizon, your risk tolerance, and your individual capital status and precisely analyze the following options in terms of financial markets investing:
Investors who choose fundamentals investing as their investment philosophy identify companies that have a strong financial position, solid earning prospects, and high financial value. They look at a company’s fundamentals such as financial statements to predict future profit, growth potential, and riskiness. It is believed that companies with sufficient cash and little debt have strong fundamentals. By analyzing the overall financial situation of the company, investors are trying to evaluate if its stocks are under, over, or fairly priced. It is also considered that businesses with strong fundamentals are presumably more resistant to economic recessions, so they seem to be a less risky investment.
Value investors also make investment decisions based on qualitative and quantitative information, which shows the well-being of the company, but with such a difference that they focus on buying stocks that seem to be underpriced. Value investors believe that the stock market is underestimating some stocks so they hunt out stocks that are being traded for less than their book value. Generally, they interpret stock price fluctuations as a stock sales opportunity. By using the overreaction of the markets, which can’t notice a solid financial situation of these companies, they buy stocks at discounted prices and expect that they will rise prominently. The most famous value investor is Warren Buffett, his mentor Benjamin Graham, and billionaire Seth Klarman.
Investors who use technical analysis rely on past market data and try to identify trends and patterns which can help them make buying/selling decisions by analyzing volume, price, psychology, and other market information over a certain period. In contrast to investors who follow fundamental investing rules, investors using technical analysis focus on uncovering patterns in trading activity by monitoring how supply and demand affect changes in volume and price. Technical analysis is usually used in short-term trading of stocks, commodities, futures, or currencies, where the focus is on short-term price movement and high volatility.
Growth investors focus on increasing their capital by buying growth stocks that are issued by small or young companies that hold the potential to grow at an above-average rate and generate significant earnings in the future. Growth stock prices are expected to increase greatly when the value of emerging companies starts to go up. Since very high returns are on the table, many investors consider growth investing as highly attractive, but only when emerging companies turn out to be successful. However, the fact that such companies are untested and often completely unverifiable makes them fairly high-risk investments.
Socially Responsible Investing
Socially responsible investors focus on investing in stocks issued by companies whose practices and values are in alignment with social issues such as the environment or society. Social investments can be made not only into individual companies but also mutual funds or exchange-traded funds (ETFs).
Socially responsible investors avoid investing in companies that produce or sell addictive substances such as alcohol, or tobacco in favor of investing in companies concerned with environmental sustainability, social justice, alternative sources of energy, and clean technology efforts.Back to top
Generally, your investment philosophy should reflect your core beliefs regarding investing. Taking into account your risk tolerance, values, time, and preferences, you will be able to prepare the right investment philosophy which will help you tune out the market buzz, focus on the most important events, and make the right decisions.Back to top