Even though you may adopt many different theories and approaches at the moment of investing, some key elements should always be considered. The primary purpose of this column is to provide a better understanding of those elements. To begin with, we will take and then further elaborate on four specific principles: risk profile, goals and time horizon, knowledge of the asset, and diversification.
A clear comprehension of these concepts is the first step towards the organization of a comprehensive investment strategy that fits the investor’s specific profile.
Risk Profile
A risk profile is an evaluation of the risk level at which a particular investor feels genuinely comfortable with when making an investment. We should remember now that every investment is an exercise based on the relation between risk and return. Thus, investors seeking higher profits will need to take positions with higher risk exposure. For this reason, setting this tolerance level as precisely as possible should be the first step to avoiding surprises caused by the results of investment decisions.
Chart 1: Own elaboration.
Generally speaking, there are three classifications of financial risk appetite: risk-loving, risk-averse and risk-neutral. However, this appetite is not necessarily transversal, i.e., the same investor may have different risk appetite levels regarding different investment types. For example, they may have a risk-loving profile concerning stocks and be risk-averse about cryptocurrencies. Why does this happen? Because when assessing an investment’s inherent risk, many variables (mainly those shown in Chart 1) are combined and intertwined to create the appropriate strategy.
Goal and Time Horizon
The next element to consider when establishing an investment strategy is the time factor, i.e., whether it is a short, medium, or long-term horizon. This aspect will determine what type of assets would be the best option and the risk appetite associated with the term.
The most straightforward way to decide on a time frame is to set up an investment goal as concrete as possible. In this way, the time horizon will be equally precise. For example, consider a person that has the means to buy a house, but the building is still in the planning phase and will not be completed for another six months. In this case, the goal defines the term, and investments that meet this six-month horizon should be sought. The main point is asking oneself the right questions. What do I need the money for? When do I need it to be readily available? Which risks can I take considering my goal? These are some aspects to take into account.
Knowledge of the Asset
As was mentioned in the risk profile section, one of its determining factors is the investor’s knowledge of the involved assets. An investor with deep knowledge of stocks that understands this type of asset’s dynamics will probably adopt a higher risk strategy when investing in this market than in other markets they are unfamiliar with. The knowledge of the particular asset and its market dynamics are essential to creating and adjusting an investment strategy that responds to these forces.
At this point, in addition to knowing the asset, investors should also understand the scope of the investment approach. In active management, the investor makes the decisions on asset selection and management. For this approach, knowledge of the particular asset is essential. In passive management, on the other hand, control is given to a fund manager that fulfills the characteristics sought. In this approach, knowledge of manager selection is also necessary.
Risk Diversification
The last element to consider is the importance of risk diversification within an investment plan. “Do not put all your eggs in one basket” is an old saying worth remembering, as it clearly explains the concept.
More specifically, risk diversification is based on avoiding the concentration of positions in one asset. By doing so, the fluctuation of the price of a single asset will not affect the results of the entire investment strategy.
In general, a strategy with several assets exposed to different risk sources reduces the total risk level, as, in some scenarios, the price of one asset falls while another rises. An ideal strategy in terms of asset diversification techniques is locating assets with a negative correlation or from different sectors, and even combining various asset classes.
Behind this analysis, we must emphasize the importance of investors being completely honest to themselves regarding their personality and risk perception profile. It is, in a way, a confession: when investors precisely disclose their information-processing, risk-assessment, and decision-making processes, the structuring of an investment plan will be more accurate.
That said, it is also worth remembering that markets always have ways of surprising us. An investor may have judiciously taken all these steps and still incur losses, so one must be prepared for any possible outcome.
This report was prepared by Gandini Análisis for Supra Brokers only as content. It shall in no case be considered an investment recommendation.
