Understanding Risk

Psychological research shows that people are systematically biased in their assessments of future
events; not only will the future be good, it will be especially good for oneself in particular.

All investors should have an understanding of risk based on an analysis of both their capacity for risk and their willingness to accept risk.

The analysis of your risk capacity assesses whether you are in a position, from a financial point of view, to accept value fluctuations. For a sound estimate of your capacity to accept risk, you should compare your income with your expenses and your assets with your debts.

Willingness to take risk, on the other hand, means to what extent you are personally prepared to accept value fluctuations. This willingness can be excessively influenced by short-term events and current market conditions. This has been described as the “cycle of market emotions” and can be illustrated thus:

“The investor‘s chief problem – and even his worst enemy ‘ is likely to be himself”

Benjamin Graham, legendary American investor, scholar, teacher and co-author of the 1934 classic, Security Analysis

There’s no place for emotions in the investment process

It is said that there are two emotions that move the market. One is fear; the other, greed. At the beginning of the cycle when the market expands, investors swing from fear to optimism to excitement to out-and-out greed. As the market peaks and contracts, investors shift from greed.

Rarely is either type of decision in the investor’s best interests, which is why investors should create an investment policy statement before they build an investment portfolio.

 

An Investment Policy Statement is a document that contains “guiding principles” for how your investment portfolio should be managed. It outlines your investment beliefs and your approach to investing, and it establishes the tangible, measurable criteria by which you judge investment decisions. As a written expression of your individual goals and your tolerance for risk, your Investment Policy Statement tells you what you should be doing, and under what circumstances.

With an Investment Policy Statement, you can break free of the cycle of emotions and instead, base your financial decisions on professional research, reasoned analysis and a thorough knowledge of your own financial goals.

Mark OByrne

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