Share this Post
This is part 3 of a 3-part series on introducing investing for creatives.
Important Investing Concepts & Strategies
This article may seem dry, boring and tedious but it is important. Most creatives do not like to study theory but all recognize and understand the importance of understanding fundamental concepts, strategies and techniques for their art.
Look at it this way, just as fundamental theory is important for you to excel in your art, the understanding of these investing concepts are essential for you to make intelligent and educated investment choices that best suit your financial goals, regardless of the stage of your creative career.
Here are 6 key investing concepts & strategies you must know:
Risk and Return
All investments involve some degree of risk. If you intend to purchase securities such as stocks, bonds, or mutual funds, it’s important that you understand before you invest that you could lose some or all of your money.
Unlike savings deposits at most countries’ national-insured banks, the money you invest in securities is not insured. You could lose your principal, which is the amount you’ve invested. That’s true even if you purchase the securities through a bank.
No matter what you decide to do with your savings and investments, your money will always face some risk. You could stash your dollars under your mattress, but then you would face the risk of losing it all if your house burned. Investing in stocks, bonds, or mutual funds carries risks of varying degrees.
In order to receive an increased return from your investment portfolio, you need to accept an increased amount of risk. Low risks are associated with low potential returns. High risks are associated with high potential returns. The risk return trade-off is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.
A common misconception is that higher risk equals greater return. The risk return trade-off tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.
Sometimes swings in the market can affect investors of all risk appetites. For example, in early 2001-2002 and again in 2007-2008, many investors were horrified that investments that had been performing so well dropped as much as 30-50% quickly. Many of them erroneously thought that because they choose “moderately conservative” investments meant that that kind of loss could not happen to them but it did.
If they were planning to retire, they were out of time to ride out a recovery that would take several years to again be at pre-drop levels, if ever depending on what they were invested in. The choice was to either retire with 50% of the income they planned on by selling investments for less than they paid for them. Many investors had no choice but to not retire and continue working longer to rebuild savings. Understanding the risk and potential performance swing level of your investments is crucial to your financial well-being.
An investor needs to arrive at his own individual risk return trade-off based on his financial & investment objectives, his life-stage and his risk appetite. But note that when it comes to your long-term financial future, the biggest risk of all may simply be to do nothing. If you don’t invest for retirement or to help meet your personal financial goals, then you are most likely guaranteed a “rat race” future.
Your time horizon is the length of time over which you expect to invest your money. It’s a key consideration when choosing investments.
Investments like cash and short-term bonds carry little risk for an investor whose time horizon is short, for example, a person saving for a vacation in 2 years. However, they can be risky for an investor whose investment horizon is long, for example, a person saving for retirement. The low return on short-term investments may not keep pace with inflation, or be enough to meet the long-term goal.
In comparison, stocks are very risky for the short-term investor since their value may change frequently. People saving for a short-term goal could end up with less money than they originally invested. Stocks have a higher potential return than cash and bonds over the long term, and are better for investors saving for long-term goals.
Longer-term investors are in a position to allocate a larger portion of their portfolio to higher-risk investments like stocks than shorter-term investors because a longer time horizon is associated with lower volatility. This does mean that stocks are not risky over the long-term, but for long-term investors, stocks are more likely to provide higher returns.
Compounding is a key aspect of investing. Sometimes called “compound interest”, it is the process of generating earnings on an asset’s reinvested earnings. Albert Einstein called compound interest “the greatest mathematical discovery of all time”.
To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.
Here is an example:
If you invest $10,000 today and assume you will get a 6% return, you will have $10,600 in one year ($10,000 x 1.06). Now let’s say that rather than withdraw the $600 dividends, you reinvest the dividends, along with your principal sum, for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year. If you reinvest the compounded earnings from the first two years, along with your principal sum, for a third year, your investment will grow once again.
This increase in the amount made each year is compounding in action: earnings growing on reinvested earnings, growing on reinvesting and so on. This will continue as long as you keep reinvesting and earning. The longer money compounds, the faster it grows. Money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.
So, each additional percentage point in returns on your investment will improve your returns on investment significantly over time. That is why, even though you will earn compounded interest with your banks savings account, you will earn drastically more with the same amount even if you choose a very safe investment with just a 1% better return. But remember, because time and reinvesting make compounding work, you must keep reinvesting the principal and earnings.
Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio.
Diversification essentially lowers the risk of your portfolio. There are three main practices that can help you ensure the best diversification:
1) Vary your investments by asset allocation. Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds, stocks, real estate, gold and cash. Each asset class has different levels of return and risk, so each will behave differently over time. At the same time that one asset is increasing in value, another may be decreasing or not increasing as much. An asset-allocation strategy looks at your particular goals and circumstances and determines what asset mix gives you the optimal blend of risk and reward.
2) Vary the risk in your securities. If you are investing in equity funds, then consider large cap as well as small cap funds. And if you are investing in debt, you could consider both long term and short term debt. It would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas. You can also vary your risk by have diversity in investing in different countries or regions.
3) Vary your securities by industry. This will minimize the impact of specific risks of certain industries. For example, even if you invest in a number of different companies in different countries or regions, but all of the companies are in the same industry; in the event of a downturn in the industry, all your investments will be affected. By diversifying your investments in different industries, you ensure that even a downturn in one industry will not affect your entire portfolio.
Investing in mutual funds is way to have diversified investments that are managed by a professional. For example, to spread your risk, you could invest 50% in equity funds, 30% in bonds and 20% in money market funds. In addition, the funds themselves will generally be diversified by industry and region.
Diversification is a very important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some sort of risk.
Dollar-cost averaging is another form of diversification; only instead of spreading your money over different stocks or bonds, it diversifies your investments over time.
A classic problem with naïve investors is to try to “time the market”. They chase performance and buy whatever was up the most last year. Then, when it goes down, they sell it and buy the next best performer, and so on. The natural human tendency is to buy lots of stock when prices are rising and to stop buying them altogether when prices are on the downswing.
Dollar-cost averaging forces you to do the opposite — you end up buying the most stock when prices are low. The Systematic Investment Plans (SIPs) or Regular Savings Plan (RSP) launched by mutual funds work on this principle and is a great investment option.
Here’s how it works: Suppose you decide to put $400 a month into a mutual fund that invests in the stocks of technology companies.
If a share of the fund costs $50 in October, your $400 will buy 8 shares. If the price rises to $80 in November, your $500 will buy 5 shares. If the price drops to $40 in December your $400 will buy 10 shares. The idea is that your money buys more shares when the price is cheap and fewer when the price is high. That lowers your total cost and, assuming the fund’s overall performance is upward, you will capture more of the upside.
That’s not to say dollar-cost averaging protects you from a falling market. If the fund’s value crashes, so does your overall investment. But the strategy does ensure that you invest new money when prices are low so that you can enjoy the run-up when the market recovers, as it always does with time.
Liquidity refers to how easily an asset can be sold and easily converted into cash. Most investors want to have some degree of liquidity in their portfolio in the event they need cash on short notice. Different investments and assets have different levels of liquidity. See an interpretation of Exter’s Pyramid below:
Cash and gold are of course the most liquid asset. Common stock is often considered fairly liquid since they can usually be sold within a day or two of the decision to sell. Some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. Property is also highly non-liquid as it is difficult to sell it at a moment’s notice.
Naturally, achieving liquidity requires a sacrifice a certain level of income or potential for capital gains.
I hope this 3-part series will get you started thinking and learning about investing. As a creative entrepreneur, depending on your specific art, you might have finite shelf-life so it is important to protect your off-stage future and retirement.