We had an interesting discussion here at Safal Niveshak yesterday. It was around my post on why I do not invest in index funds.
Some readers gave very valid reasons why index funds are a great way to invest for small investors given that these take away the big risk of a short-term focused fund manager and his inadequate stock picking skills.
Another valid reason readers gave was that a small investor does not have the time to put in the effort of selecting good stocks and mutual funds…and thus index investing is a good way to go.
This is what I replied to one of the readers…
I would like to say that not having Index Funds in my portfolio is my ‘personal’ investment strategy which I wanted to share with my readers. I have not said that no one must have Index Funds in their portfolios.
The choice is very individual and is dependent on the kind of risks one can take and the investment horizon. So it’s purely an investor’s personal call whether he must/must not have Index Funds in his portfolio.
Now, if you’ve read this comment, you might ask me – “Why do I care what’s your ‘personal’ investment strategy? Tell me what’s right for me because nothing else matters!”
Well, dear reader, if you have been with Safal Niveshak for long, you know that my core idea here is to NOT enforce upon you what ‘I believe is the right way of investing’…because there’s no right or wrong way of investing.
My idea through Safal Niveshak is to help you understand ‘yourself’ better…so that you can frame your own investment strategy – one that is highly personalized to your style, habits, and what keeps you awake at night.
In effect, I am just acting as a facilitator to guide you towards self-realization as an investor.
Today’s post works in that very direction – to help you with some simple questions you must answer to better understand the kind of person you are…so that you can develop a personal investment strategy.
You see, there are basically three aspects that can help you create a personal investment strategy:
- Your personal tolerance for risk
- Your financial goals
- Your time horizon
All the points we discuss below will revolve around these very aspects. So let’s get started.
5 steps to create a ‘personal’ investment strategy
These five steps are basically five critical questions that you must answer to formulate a personal investment strategy. Here they are…
Step 1: Am I a stock or a bond?
I ask this question again and again on Safal Niveshak. And this is the first question you must ask yourself while devising your personal investment strategy – “Am I a stock or a bond?”
You are well aware of the fact that a stock is a share in a company, and thus its performance is dependent on how the company’s business does. In short, a stock’s future performance is unpredictable. This is because it is backed by a company that has inconsistent earnings (in most cases) and subsequently inconsistent performance.
You also know that a bond is much safer than a stock as it ‘guarantees’ a regular income (in the form of interest) and a confirmed payout at the end of a predefined time.
So coming to the question “Are you a stock or a bond?”…the answer lies in understanding yourself – your life, and your career.
You are a bond if you have a stable job that is unaffected by the volatility of the stock markets. And you have many years left to work.
So to balance out, you should have a higher proportion of your savings invested in more aggressive investments like stocks and equity mutual funds.
On the other hand, you are a stock if you have little years of work ahead of you, or if you work in a volatile and unpredictable field that could decline quickly with little notice (like the stock markets itself!).
So to balance out, you should have a higher proportion of your savings invested in less aggressive investments like bonds and fixed deposits.
What this stock/bond question answers is how you look to the idea of integrating your ‘human capital’ with your ‘financial capital’. It answers how you can integrate your work outlook into your investing plan.
And since each person has a different kind of ‘human capital’, the answer to the question of how much one should invest in stocks and bonds differs from person to person.
Step 2: How strong am I emotionally?
We humans have a terrible design flaw. When it comes to investing, we aren’t just built for it.
We have a tendency to see order in randomness. We find patterns where none exist. While this trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is harmful when it comes to investing.
Investing is a game of emotions – the less emotional you are, the better will be your long-term performance as an investor.
So when someone asks me – “Do you think I should invest in stock markets?” – I ask back – “How strong are you emotionally?”
If you count ‘patience’ among your strengths, you are well-suited to long term investing where patience will earn your great returns.
But if you are a nervous wreck – which I was till a few years back – you will be safe staying in the company of bonds, fixed deposits etc.
But whatever you do as an investor, never try to go against your basic nature. Never try to suppress the real ‘you’ or you might end up with demoralizing results.
Step 3: How much risk am I willing to take?
Even after you know whether you are a stock or a bond, or how strong you are emotionally, you must also know your ‘willingness’ to take on risks that come with certain investments (like stocks and mutual funds).
One key factor that defines the level of risk you can take is your level of understanding about various investment options available.
So while I might claim to be an expert on stock markets, my level of understanding on other avenues like fixed income and debt might be extremely weak.
This is also true for you. Being a banker, you might know more about banking stocks than a fund manager managing a banking fund.
Or having burnt your fingers in dud equity funds (and 95% of them are real duds), you might believe investing in index funds is a safer strategy (which I believe is perfectly alright based on how you perceive things, though personally I have my reservations about index funds).
So you need to be very clear about the level of risk you are willing to take, and about the type of investments that suit your risk profile.
Step 4: What are my life goals and when are they due?
This is a very important question in the preparation of your personal investment strategy.
You must be very clear of what your financial goals are and when are they due. In other words, your investment choices must always be driven by why you need the cash for and when.
So if you are looking to accumulate money to send your child for higher education in 3-5 years, allocate just a marginal amount of money (say around 10-20%) to stock markets. Keep the rest of your capital ultra-safe – bonds, FDs, liquid funds, etc.
On the other hand, if your financial goal – like child’s education or buying a house – is 10-15 years away, employing a large portion of your savings in stock market is a ‘safer’ strategy than keeping them in bonds and FDs.
The thing is that the longer your investment horizon, the lesser you must worry about the short-term fluctuations in stock prices. After all, in the stock market, return and time are painstakingly related.
Step 5: How much can I afford to invest?
The answer is – You should only invest money you can afford to lose.
A more constructive way to consider it is: “If I lost this money, would it affect my day-to-day life or expenditure?”
So the first thing to do before you start investing is to repay all your debts – at least ones that need to be repaid in the next 2-3 years.
You also need some money for the proverbial ‘rainy day’. A sensible rule of thumb is to set aside enough money for 8-10 months’ expenditure in a high-interest savings account.
But you may feel happier setting aside more money if, for example, you have a number of dependents.
After you do this i.e., repay your short term debt and create an emergency fund, start investing for wealth creation to meet your long term goals.
Why you need a personal investment strategy?
If there’s one certainty about investing, it’s the certainty of losing money by randomly picking investments on a whim.
You are a very rare investor if you can consistently pick great investments solely through gut feel or intuition.
Alternatively, forming a set of sensible guidelines and having the discipline to stick to them should keep you involved in investments that are more suitable for you.
Whether it’s considering companies of a certain industry (your circle of competence), or keeping to index funds, remaining with what you know best and feel comfortable with should limit any investing heartache.
Always remember one thing – You can win the investing game only when you play according to your own rules…and not those set by a maverick, like the one you know as Vishal Khandelwal. 🙂
You must also remember that however hard you try to win the investing game, you will still fall several times in your journey.
Of course, I’ll always be there to try and sort out matters for you…but I can only help you identify the stumbling stones where you can fall, so that you get ‘less’ hurt than most other investors.
I hope that sounds fine. What do you say?