You walk into a financial institution and sit in front of an investment adviser or client service representative. You have some money to invest and, with some apprehension, indicate this to the person sitting across the table. As the conversation evolves you are asked whether you want to take on low-, medium- or high-risk investments. Confusion begins to take over and the way out is often when your adviser asks you a series of questions in order to assess your tolerance to risk.
At the end of that process a recommendation will be made as to the types of investments that are suitable for you and an investment portfolio developed. Your risk tolerance, as assessed by your financial adviser, attempts to ascertain your comfort level with changes in market prices and volatility. If you are comfortable in this environment then stocks will likely form part of your portfolio mix. If you are deemed to be uncomfortable with volatility then the portfolio will be skewed towards fixed income products.
This approach is fairly widespread even to the point where it is considered to be standard practice.
Many will be familiar with this process when seeking investment advice. Even the regulators encourage this practice as it seems to be able to determine whether an investment is suited to your needs or not.
The problem with this approach is that it is all backward looking. Your ability to accept volatility in the price of your investments is a function of your prior experience first and foremost. If you are experienced with market volatility then you will be less concerned.
In addition, your current financial status (which is built up over time) would also impact your ability to handle volatility.
Someone in their twenties with no prior investment experience is likely to come out as very intolerant of risk and so would be placed into a fixed income portfolio. This is because they have no financial buffers and have little experience with market price fluctuations.
Yet they have an investment horizon that spans over 20-30 years and beyond and there is no stock market in the world that has not shown a positive return over such a long-time horizon.
Very often the suitability tests that you encounter position you in a way that may not best suit your investment needs and this is something to consider as you participate in the process with an investment professional.
For many other investors you may not even get to the point of determining your suitability for a particular investment as the investment professional focused on meeting a sales target or quota jumps right into the mix of making recommendations based on the cadre of products that they have to sell.
In this scenario it is often a situation of luck and chance to arrive at a successful investment outcome as you may inadvertently be placed into a product that performs well over time or the opposite may happen. When that is the case, the easiest option is to blame the market for the lack of performance.
Made to spend
To find a way out of these all-too-common scenarios the key principle I want you to grasp is that money is there to be spent. A significant portion of your life is taken up trying to earn money and another significant portion goes toward spending it. The question, therefore, is not if but rather when you choose to spend your money.
You can either choose to spend it now in the form of consumption. Spend what you don’t yet have, in which case, you incur a debt. Or you can spend in the future in which case you may want to save or invest the sum relating to the spending that is being deferred. If you don’t spend it then it goes to your successors and they will spend it. Whichever way it goes, the money will be spent.
If you are going to spend your money in the future then what you do with it today is to either save or invest it in the hope the funds will be available for you in the future to spend as you so choose. If you appreciate this point, then you should be able to take the next logical step and recognise that before you walk into the meeting with the investment professional you should give some thought to what the money you are seeking to either save or invest is going to be use for.
There is a difference between saving and investing.
Saving involves the accumulation of funds while investing involves trying to seek a return on those funds. You need to learn to save before you decide to try your hand at investing. In fact, you need to learn to save before engaging in just about any other financial activity.
This is where parenting comes in and those that have been blessed with an understanding of how to treat with money as taught by their parents have a distinct advantage in life. The one thing we are sure to witness as children is how to spend.
Our parents will take us to the grocery, they will take us shopping, they will buy stuff for us. We observe how they spend. It may, however, be a bit more difficult for a child to observe how parents save. Yet, this is a fundamental skill in dealing with money.
Most people upon finding a job are wont to take out a loan. This may be for the purpose of buying a car or it may simply be the case of getting a credit card to make spending easier. What most people don’t appreciate is that the discipline of saving is exactly the same as paying back a loan. Despite this I have heard it many times from people who are in debt that they find it difficult to save.
Repaying a debt involves making periodic payments, called installments, to the bank or other lender, usually each month. Saving—which I have already defined as the accumulation of money—is the reverse but it involves the same steps and actions.
If you are taught how to save then you are simultaneously taught how to borrow and repay a debt. If you have difficulty in setting aside a sum of money on a periodic basis as savings then you should not go anywhere near borrowing money because then you can find yourself with an obligation that you cannot fulfill.
Teach our children to save
I urge parents to teach your children how to save. It is more than just setting up an account and letting money go into that account every month, not to be seen or known about by the child. Without savings you have no surplus money to invest and you will be challenged to adopt the behaviours that are required to pay back a loan.
Saving is a fundamental and necessary skill that you should nurture your children towards so they become proficient at it.
Having grasped the concept of saving and investing and being taught how to save, applying that understanding to what your money is to be spent on becomes relevant. If money has a purpose then it is likely to be used wisely. If it is not given a purpose then it is likely to be frittered away on whatever temptation comes before you at a point in time.
When you want to determine which investments are appropriate for you the purpose that you are going to use the money in the future is more important in determining where to invest than your risk tolerance. The tolerance for risk is exactly that, a tolerance, and this is something that can be learned and understood over time with the appropriate coaching from your financial adviser.
If you intend to spend money accumulated now in 30 years’ time then your current tolerance for changes to the prices of the investment instruments is of little consequence. If you intend to spend money accumulated now in a couple years time then changes to prices can have a significant impact on whether you would be able to use the money you have set aside in the way that you want to in two years’ time.
Always ensure you have established a purpose for your money and, as far as possible, stick to the intended purpose.
To do this properly you need to have a clearer idea of what you want out of life and how money can enable those aspirations. That’s where the conversations should start, but in order to have such a conversation you need to have some idea of what you want beforehand.
Ian Narine can be contacted via email at [email protected]