Basic Concepts and Definitions
To be an astute investor you need to be knowledgeable about some basic concepts. In this posting I discuss some critical concepts that will prove beneficial.
Risk- is the uncertainty of an investment’s return. It is critical to appreciate that in the world of investments there is a certain element of risk that you may lose the investment or you may not get good returns. Risks are reduced by be knowledgeable and realistic in your assessment of the risks involved. One can take steps to reduce the risks associated with each investments class. Not every investment carries the same level of risk. Savings have guaranteed return and no risk. Stocks carry risks because they fluctuate.
Volatility- is the degree to which the value of an investment tends to fluctuate over time. For example stock prices can move up and down on a daily basis whereas a real estate investment is not as volatile on a regular basis. Volatile investments are not wise for a temperamental person. When it comes to volatility, one should realize, that the fluctuations may be just phantom increases or decreases as the real value is obtainable at harvest of the investment. So the longer the investment horizon the less perturbed and investor is with volatility.
To a certain extent it could be said: The higher the risk of investment, the higher the volatility and the higher the potential returns
Risk tolerance- is the amount of risk that you are personally comfortable accepting in your investments. It is affected by your time horizon and your personal response to risk. Time horizon- is the amount of time you have before you need the invested money back. The greater the time horizon the greater your risk tolerance as short term changes in investment performance does not affect you.
- How you personally feel about taking risks and losing money- personal response to risk.
- Do you avoid risk at all costs? Avoid high risk investments e.g. stocks
- If you enjoy risks- go for growth investments- those that increase in value overtime.
Investment portfolio- is a collection of various types of investments that you hold. For example real estate, listed stocks, unlisted shares, businesses owned, passive income through Intellectual property. Asset allocation- is the process of determining the percentage of your investment portfolio that each asset class should occupy based on your risk tolerance. Overall purpose of asset allocation is to reduce volatility, so that thriving investments in one asset class potentially outweigh losing investments in other classes. One should own various asset classes.
Diversification – is owning various investments within each asset class e.g. stocks from various industries, with the intention of decreasing risk without compromising returns over the long term. Diversification is prudent for an investor. Many budding investors are misled by seasoned investors who discourage diversification. I attended a seminar where a renowned businessman in Zimbabwe was discouraging diversification on the basis that one should be focused. However when one analyses this businessman’s investments, one discovers that he is significantly diversified as he holds equity in financial services sector, hotel and leisure, real estate as well as owning businesses that range from commodity broking, travel, estate agency etc. Similarly renowned wealth creation expert Robert Kiyosaki discourages diversification – calling it “di-worsification” —- but an assessment of his own investment portfolio does show a strongly diversified portfolio with publishing, seminars, stock exchange listed portfolios, and businesses spanning various industries form precious minerals to energy and financial services. What this teaches a novice is that be careful as people sometimes show a discrepancy between their espoused values and the values they live. One should exercise a healthy sense of skepticism when they are learning on investments or anything for that matter. Accepting anything without questioning makes one gullible.