Editor’s note: This article was first published in December 2010, and its closing paragraph was revised in September 2012; the view that it was not the time to be in the stock market and that another crash was coming reflects that moment and is long out of date.
First and foremost, before investing in any kind of investment or vehicle, we need to know it inside out, just as we need to know the alternatives. We also need to know where the investment is taking us and whether it fits our purpose. Let me explain. We all know there is fixed income and equity. Fixed income (fixed-term deposits, sovereign debt…) is a way of earning a “little bit” of return on our savings, although depending on the interest being paid at the time, it may only help us keep up with inflation.
However, if what you want is to get rich or to have strong purchasing power 10 or 20 years from now, fixed income will only serve us for a while, while we learn about investing. You will never get rich without taking risks. That said, let’s look at all the points you should analyse before jumping into investing.
1. What is your risk tolerance?
Many investors “put their foot in it” here, because they invest without knowing their risk tolerance. There are two kinds of risk tolerance:
- Financial or economic: You need to know exactly how much money you can afford to lose, and only invest money that either you won’t need for the next five years or that you could afford to lose, because even though it isn’t common, you should know there is always a risk of losing everything. If you do end up losing everything, it should be money whose loss doesn’t affect your day-to-day finances. Even so, even if you do things fairly badly, the probability of this happening is practically zero.
- Psychological or emotional: Even if you can afford to lose that money, is the investment going to keep you awake at night? You need to keep an eye on the markets, but not be obsessed with them. Some people, once the market has closed, see a piece of bad news on television and are already worried, unable to sleep all night while they wait for the next day. So, will you be able to lead a normal life once you invest? You should know the protection mechanisms available on the stock market, such as the well-known stop loss, to cut a loss short, although this brings us to the next point.
2. Are you a short-term or a long-term investor?
It is important to define this, because it changes everything about how you invest, the stocks you choose and when you enter the market. We could divide investors into three types:
- The trader: This investor lives the stock market day by day. In fact, their trades are intraday (they don’t hold shares overnight). We have already talked about the drawbacks of this kind of investing and explained that 90% of traders basically lose money. But they have one very good thing going for them: win or lose, they sleep well at night, because since they hold no shares, nothing is at stake while they sleep.
- The undecided investor: This investor can be short term or long term. They look for short-term gains, and as soon as they have a return they consider sufficient, they sell the shares. Sometimes the short-term investment goes wrong and they have no choice but to turn it into a long-term one.
- The long-term investor: When a long-term investor is seasoned in finance, they analyse several companies, their technical and fundamental analysis and their future prospects. They also weigh whether they are better off choosing a company that pays good dividends or, on the contrary, one that has been badly beaten down or is just starting out. They are not worried about day-to-day news and don’t usually mind if the company they invested in loses 15% this month, especially if they are confident that there is a high probability the company will multiply its value within three years. They also tend to diversify across several stocks or different investment products (shares, commodities and currencies).
3. A minimum of knowledge.
As I said at the beginning, the least we can do is understand the investment vehicle we are going to use. Nobody should invest without a minimum of knowledge. Learn to tell the difference between a mutual fund and an exchange-traded fund, and find out how a specific situation would affect a share. I have sometimes heard people say (even if it sounds like a joke): “I’ve invested in company **** because tomorrow it’s doing a capital increase.” Buying shares without knowing that a capital increase dilutes the share price is like going boar hunting with a slingshot.
Going back to the points above, it can also happen that an investment keeps us awake because we didn’t invest well, and deep down we know we made a bad choice. Fortunately, on the stock market you can correct that mistake whenever you want, because one principle of investing is that if a share doesn’t behave the way you expected, you shouldn’t let the losses run if your intention isn’t to hold it for the long term. Likewise, never sell a rising share just because you think it is expensive. Place a trailing stop (one that adjusts to the price as it rises), so that it is the market itself that sells it at the first sign of a change in trend.
You should know the risk you are taking depending on when you enter the market. Entering a bull market is not the same as entering a bear market, because even if you are a long-term investor, why miss out on 20% for not waiting a few more months?
I am going to write a follow-up to this article for those who plan to invest for the long term, because they will need some different skills. I repeat that, as of 19 September 2012, I don’t think this is the time to be in the stock market, and that is why, when the market collapses again, we will be able to apply other kinds of strategies to catch the bull market (and for the long term, if that is what you want).
Featured image: ZooFari, Public domain, via Wikimedia Commons.
