Investing 101: Part 1 - Stocks, Bonds, Risks, and Capacity/Tolerance

 

Students: It is important to first understand how a stock and bond function before we can learn about mutual funds/ETFs (that are made up of individual securities). It is also critical to understand RISKS and how investor capacity/tolerance influence appropriate investment selection.

Individuals: This is a great place to start if you are new to investing!

Advisors/Professionals: Understanding your clients capacity (time horizon, financial situation) and tolerance (stomach for risk) is VITAL to investing appropriately for them. Also understanding and explaining risks so clients are fully aware of what could affect their portfolio/planning.

Investment Basics: Stocks vs Bonds

  • (more to come soon)

 

Investment Risks

  • Systematic vs Unsystematic

    • Systematic risks affect everyone (regardless of diversification) and can be minimized (offset with negatively correlated risks or “hedging”) but not eliminated.

      • Examples of these types of risks: Interest rates, market, tax/political, inflation, environmental, social, etc…

    • Unsystematic (or business specific) risks don’t effect the whole “system” and expose individual companies to additional risk. Can be largely eliminated by diversifying into 30-60+ securities (or investing indirectly through mutual funds/ETFs which are typically holding 50-1000+ securities).

      • Examples of these types of risks: management, market share, credit, liquidity, operational factors, etc…

 

Investor Capacity and Tolerance (investor “profiles”)

  • It is VITALLY IMPORTANT to understand your (or your client’s) capacity and tolerance for risk. These are the building blocks of outlining their asset allocation and portfolio design.

  • Investopedia article on capacity/tolerance

    • Which is more important - capacity or tolerance?

      • Capacity = time frame (HUGE), dispersal period (lump sum vs payout over time), and other financial factors (fixed income, savings, credit available, other assets owned, liquidity, etc…).

      • Tolerance = your “stomach” for risk (IE what roller coaster can you tolerate riding?). Given a handful of different portfolios, which one are you comfortable with the ups-n-downs.

      • CAPACITY > Tolerance = capacity ALWAYS trumps tolerance.

        • Let me give an example: I have a high tolerance (stomach) for risk (so I should invest aggressively right?). If I’m saving for my kid’s college in 3 years should I be “very aggressive?” NO!! I shouldn’t - because the timeframe (short = 3 years) and the dispersal period (fairly short = 4 years) lend towards investing conservatively (or really just sticking in a savings/money market account). Another example: If I have a low tolerance (stomach) for risk and am saving for retirement in 30 years I should be conservative right?? NO!!! Based on the capacity = time frame (LONG = 30years) and dispersal (retirement over 20+ years) I should be moderately aggressive (maybe just not “very” aggressive since my tolerance is lower).

        • Capacity also includes other financial factors. A retiree that has social security income, a pension, 200k in the bank, and low expenses could afford to take risk with their remaining investment account (say it is 500k). Why? Because they have strong fixed income, plenty of cash on hand, and low expenses! These “factors” lend to the ability to investment more aggressively because they can “ride out” the ups-n-downs of the market. Compare this with a retiree that has low social security income, no pension, and 5k in the bank and higher expenses. If they had a $1m 401k, they might need to invest a bit more conservative as they will be taking larger systematic distributions and don’t have a safety net of cash.

        • My personal preference when looking at the investor profile’s below are the ones that segment capacity vs tolerance and/or place a much higher rating on capacity.

  • Here are some different risk questionnaires or "investor profiles." Which one do you like best? Why?