Defining the “Perfect” Investment
If you asked a room of 100 people to define the “perfect” investment, you may not get 100 answers, but you’d certainly get more than one. And more than one answer may be correct! The criteria for judging the merits of an investment include the investor’s risk profile, time horizon, and goals. This sheds some light on the fault of the original prompt for this post, an article about “stomaching” the perfect investment – while there is almost certainly no one “perfect” investment, it is possible to develop an approach to investing that can build a portfolio that fits an individual’s needs perfectly. For the purposes of this piece, we’ll limit the possible ingredients of said portfolio to stocks, bonds and cash.
Before an individual begins to invest, it is critical that they develop an understanding of their unique risk profile. Let’s start unpacking the term “risk profile” by looking at the three parts that comprise an individual’s risk profile:
- Risk Tolerance: Refers to the trade-offs that an individual is willing to make when faced with uncertain outcomes. This tends to be a stable characteristic that shifts only slightly over long periods of time.
- Risk Perception: Represents an individual’s perception of what the trade-offs actually look like in the current environment. This characteristic is very unstable and can vary widely as a consequence of changing external circumstances. Risk perception can stabilized through the accumulation of experience and/or education.
- Risk Capacity: Refers to the availability of resources that can mitigate financial risks. For example, an individual can increase their risk capacity by receiving multiple stable sources of income or by building significant cash reserves. This is something that can be improved through financial planning.
While an investor may think they know their risk profile, using outside resources can help ensure this is true. For example, one can learn more about their risk tolerance by taking an assessment and reviewing their scores. From there, engaging a financial planner can help them manage their risk perception, develop a strategy to increase their risk capacity, and build a plan that will help them meet their goals.
Time Horizon and Goals
When developing that plan, the individual’s time horizon for meeting each of their goals will also need to be defined. The time horizon of the goal, within the context of an individual’s risk profile, is the key driver in determining the investment plan for achieving it. Some goals, like funding retirement or education expenses, take years or even decades to achieve. Others, like saving for a down payment on a car or building an emergency fund, can be accomplished more quickly.
For big goals with long time horizons, investing in a mix of stocks and bonds makes sense because doing so enables the investor to capitalize on the magic of compound interest over time. The longer the time horizon, the greater the capacity for risk; as such, a greater proportion should be allocated to stocks to capitalize on their higher upside potential (especially for big goals that can only be achieved via a combination of savings and investment returns). As the investor gets closer to the end of a given goal’s time horizon, the mix should shift more towards bonds and cash to secure the value of the portfolio while still maintaining the ability to grow. In contrast, if a goal is small enough that it can be achieved by setting aside cash for a few months, investing in stocks or bonds may be inappropriate – the potential for significant positive investment returns is mitigated by the short time horizon, as fewer compounding periods lessens the potential upside.
For more on Yeske Buie’s investment philosophy and approach to developing the “perfect” portfolio, check out the links below.