📊 The Chart All New Investor's Should See Before Investing
Diversification helps to reduce risk.
Don't chase returns.
Understand your risk tolerance and your capacity to take such risk.
How much risk did I take to make this money?
Can I take less risk and make the same amount? 🤔
One well-known investing principle is diversification. Have you heard of it?
Or the saying, "don't put all your egg's in one basket," because if you trip and fall, you risk breaking all your eggs. 🥚 🍳
This applies in investing because if you're invested in one specific company (i.e., Apple, LuluLemon, Uber, Snap), a specific industry (i.e., technology, health care, financials), or a specific country (the U.S. vs. Emerging). You run the risk of being concentrated and over-exposed to risk.
The figure below ⬇️ shows the performance of different asset classes going back from 2006-YTD (Year to date).
The stock market is one big universe broken down into sub-universes, "asset classes." Asset classes are the different segments of the markets you can put your money to work. What we see is that no one asset class is superior year after year.
One example is the "EM Equity" asset class [purple square], which represents emerging markets (what does that mean ❓ it's countries that have not been fully developed to its full potential compared to more developed country [i.e., U.S vs. South Africa]). The EM equity in specific years is the best performing asset class, generating the highest return for investors but years following, the worst-performing. Timing of investment purchase has a significant influence on performance (short and long term). Look at 2007 📈 vs. 2008 📉 ... the reason why market timing is so hard. Most novice investors try to time and chase returns. They see how one asset class is performing one year, wanting a piece of the action, buys it, and the asset price drops... 📉
The "asset allocation" asset class [gray square] is a balanced portfolio (50-60% equities and 40-50% fixed income) with a mix of all the asset classes. Not the best performing asset class among their peers (annualized 6.7%), but investors experience less risk/volatility. Not on the top winners or worst losers board but ranges somewhere around the middle.
For younger investors with a long-time horizons and higher earning potential plus other various factors, investing in risker assets "may" make sense if you can stomach the swings. As investors get older and near retirement, the focus shifts from accumulating wealth to preserving wealth (investing in less risky assets). Individuals may save/invest into their 401K's and IRA to one day use this money to help replace their income in retirement. But imagine if this retirement account was slashed in half, 50% 😱 because they were overly exposed to risky investments? One benefit of working with a financial advisor is that they help their clients build an investment plan according to their goals and make adjustments to their life chances.
Don’t get me wrong, making money on your investment is a great feeling but remember that the investment return (% or $) you see isn't everything. Investors should evaluate their investment management skills (or stock picking) performance by the amount of risk taken. (how do I calculate this? Look up Sharpe, Treynor, or Jensen ratio)
Which would you choose:
A. 10% investment return with a chance of losing 100% of your investment
Higher return but more risk of losing it all.
B. 7% investment return with a chance of losing only 50% of your investment
Lower return but less risk of losing it all.