Let us talk about Risk Reward Trade-offs today. When I say Reward I am alluding to the returns that you get from an investment. This also includes capital appreciation. Risk refers to not receiving the desired reward from an investment or also the final reward being lesser than what you expected. Risk and Reward are the two sides of the investment coin.
Points to Remember for The Investor
- Investments that offer higher returns are not really investments that are safe.
- Investors must take a hard non-prejudiced look at their own risk acceptance levels before they select an investment. They should understand whether they are ok with a higher return vis-à-vis a bigger risk attached compared to a lower but certain return with assured capital safety.
- An investor must decide the risk-return trade-off level whereby he receives the best returns for his monies and whereby the risk level is lowest.
- Lower risk levels are associated with lower returns. For instance the safest and most liquid investments are savings bank accounts where the returns are as low as 4% p.a.
- Guaranteed returns with capital protection are lower because the guarantor will charge guarantee fees.
- Before you make an investment, you should study the risk profile carefully to assess whether the returns are in proportion to the amount of risk involved.
When Should You Not Invest
Over enthusiasm can often become a money killer. Over enthusiasm is a habit that can ruin many a good prospect including investing.
Do Not Invest
- When you have debts and loans taken at high interest rates that are outstanding. If you happen to have surplus funds available, common sense indicates that you repay the loans rather than invest the amount.
- When you have to forego your basic necessities after you invest.
- When you do not fully understand an investment product or scheme and it’s associated risks. E.g. stock futures and options.
- When you do not have contingency funds in place.
- When you have outstanding credit card payments because a high rate of interest is charged on late payments.
- When you have to borrow money to invest.
Common Mistakes When Investing
- Bad Timing: Buying when the markets are rising and selling when the markets are declining.
- Herd Mentality: Not doing your homework and investing in just about any product or selling or buying a stock just because everyone and their cousin is doing so.
- Unrealistic Goals: Exiting from an investment at levels that are unreasonably high.
- Unclear Investment Strategy: The investor has no investment strategy or has no idea about whether a chosen strategy is right for him.
- Endowment Effect: This means getting overly attached to your investments even when selling them can prove to be profitable.
- Excessive Trading: Buying and selling holdings frequently and prematurely and before the stock reaches it’s full potential.
- Poor Diversification: Over or under-diversification are both bad investing habits.
- Psychological Errors: Immediately selling investments that post a rally in prices after previously declining in value due to unfavourable market conditions.
- Bad Attitude towards Losses: Most investors do not like to take a hit even when it becomes important to take a loss to prevent more losses. It is always prudent to take a small hit now and prevent a bigger hit tomorrow. It is a human fallacy to never admit to making mistakes.
- Anchoring: Anchoring means that an investor has a fixed idea and opinion about an investment. In reality, there is no investment that is good or bad as long as it gives you good returns at low risk.
- Familiarity Error: Investing only in stocks of companies that you are familiar with in spite of mounting evidence that they may not be good bets.
Qualities of a Successful Investor
- Ability to wait for a sufficient long time to reap good solid returns.
- Ability to do a lot of research so that he can make educated investment decisions.
- Ability to be disciplined, systematic and regular in making investments.
- Have an individualistic nature and not follow herd mentality.
- Must not be hasty in exiting an investment.
- Ability to be cool even when the value of his investments is declining. Fearlessness is the number 1. Quality of great investors.
- He must keep an open mind about market developments.
- He must be capable of taking quick decisions based upon the market information.
Over and above all these points, the investor must remember to establish clear and tangible goals. If you do not have clarity then you are likely to lose enthusiasm midway. When you are clear about the objectives of your investment activity then you are instilled with a sense of purpose and the financial discipline to make you hurtle towards achieving your financial objectives.
As an investor you must be very specific about your goals. If you make statements such as, “I want to be rich”, or “I wish to become as wealthy as possible” are vague. Instead you should set goals such as, “I will invest an additional Rs. ____ every year for _ number of years for the purpose of meeting ____. Or I intend to build a corpus of Rs. ____ by the year 2040 for my retirement (or any other purpose).
The above are just two examples of specific goals that can help you strategize. Always keep your financial status in mind when you set these goals. Write down the goals in your diary or planner and keep revisiting them from time to time lets say every six months or so to check your progress. This method of investment can work wonders and is proven to be fail-proof.
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