The Suitability Of Stock Investment For You

The suitability of stock investment for the individual is of paramount importance.

When choosing an investment, there are always many alternatives and as such it should be possible to pick the perfect thing. Despite the informational bias on this site, stocks and equities are not usually suitable for everyone or on every occassion. Therefore, the suitability of stock investments for you, the individual, is and always should be an issue to consider.

In most five to seven year periods, the returns of stocks and shares has comfortably beaten inflation in the major markets and economies. But, as is always repeated, past performance is not necessarily a guide to the future.

The general increase in business and productivity results has worked its way into long term rising capital prices and dividend incomes. This in turn leads into increased performance of pooled equity products such as mutual funds, unit trusts, life assurance investment products, SICAVs and more.

Hold On...

There have been incredible short term fluctuations in capital values. It is this volatility that prompts advisers and writers everywhere to mention the 'medium term' as a minimum holding period. The income stream from dividends has, however, proved to be relatively stable.

Stock market based investments (details here) offer an opportunity to make a real and positive return on an investment. Yet, they should only be considered by people with a time frame of at least five years.

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This is a very important point. Your author has found himself in more than one situation where I was forced to sell an investment at a bad time. Theoretically I knew that I needed to hold the positions for potentially a very long time, but the harsh realities of life meant that I had a very real need for the money, NOW!

This has lead me to a guiding belief that investments should always leave a good amount of cash - by your standards - in the bank. Wall Street can be much too variable and if you have a liquidity need, you can bet that prices will not be in your favour.

Therefore, the suitability of stock investment is very low for people with a short time scale and those who cannot afford to see their investment lose value - even if only on a temporary basis. Direct investment in companies on the stock market can be very risky.

Like Links In A Chain

It also ought to be pointed out that history has shown again and again that the kinds of events that cause us liquidity problems are often related or correlated.

This means that when the economy starts to slow, firms make redundancies and reject requests for pay rises. This can lead to personal financial difficulties - of course - that create a need for money. However, these same difficulties might have reduced the value of your assets as well (residential property as well as stocks and shares). Therefore, the time that you are forced to sell might be a very bad time to sell.

Before The Stock Market

General financial planning principles recommend that any individual uses spare money for other things before making direct equity investments. For example, it is important that an emergency fund be made and held in a cash account should there be a short term requirement for money.

Other longer term financial products should also be considered. These should include CDs, timed deposits, an annuity, bonds and debt instruments.

One often used calculation used to guide investment portfolio planning is to start from a position of 50/50. That is 50% in the stock market and 50% in bonds (bonds are debt instruments that have fixed repayment terms and maturity dates and are thus considered to be lower risk).

From that 50/50 start, a number of calculations offer guidance by lowering the proportion to be invested in the stock market by considering the age of the investor. The general investment consensus is that the older an individual is, the less risk they ought to be taking in the market (since most people will need to preserve capital and use it to generate an income in retirement).

Many individuals will therefore find that their professional guidance suggests a split of somewhere around 60/40 to 70/30 (bonds/stocks).

Be Low Beta

For many people, a much more sensible option than any investment will be the repayment of short term debt. These might be credit or store cards or overdrafts - essentially, anything with a high compound interest rate should be repaid before investing directly into stocks.

Once this repayment is complete, it is usually advisable for an investor to start with some form of collective investment, such as a mutual fund or unit trust. This lowers the risk involved in the investment and hopefully provides time for the individual to get used to seeing annual reports and reading more about the economy and market in the daily news (we all take economics much more seriously when our own money is invested!).

As Wall Street Journal writer Robert Frank discusses in his 2011 book The High Beta Rich (reviewed here by the Financial Times), a lot can go wrong when all of a person's net worth is invested in the stock market.

To quote the above book review, "If someone has a stock portfolio of, for example, $100m, it does not represent real wealth. Rather it is a claim on the profits that it is believed the underlying companies are likely to make in the future. If expectations change, the value of the portfolio can easily slump, as many of the wealthy have discovered to their horror".

His book describes many people that had borrowed heavily to fund their glamorous lifestyle based on their large holding in a family business or tech company that they had floated on NASDAQ (details here) or NYSE (details here). When prices dropped, their lives had to be severely reigned in because they simply did not have the income or capital to maintain interest payments on their many large loans. By holding the majority of their net worth in just one company (their own!), they had minimal diversification which negates much of the effectiveness of stock investment and portfolio management theory (details here).

Therefore, it is vital to understand the idea of personal liquidity as it relates to outgoings and debts to understand the true suitability of stock investment for an individual.

If this sounds a little complex, don't worry, you are not the first to think that. In fact, liquidity problems have troubled both retail and investment banks (many in 2007-9 were unable to roll over their debt in the markets) and even in hedge funds where risk management is something of an obsession. This means, alas, that we are all likely to get things wrong at times, but the real trick is to have as little dangerous exposure as possible. Be careful.

Mind Your Head

There are other people for whom the concept of risk is just too scary to tolerate. We have all met such people. You might be one. The idea of losing even one dollar is terrible for them and they would most probably become mentally unhinged while tracking the value of their stock or fund holdings hour by hour. The lack of stability of stock investment just is not for them. This also really calls into question the suitability of mutual fund investment for them as well.

For such people, Wall Street is probably a roller coaster too far and it will be better for their mental health if they simply avoid all contact. However, if these people (you?) has a mathematical and analytical mind, this aversion to loss might make you a very good contrarian or value investor. If this describes you, whatever you do, do not take up day trading!

The sad reality is that since the 2008 financial crisis, most of the major stock exchanges around the world have become much more volatile and far weaker. There seems to be lots of money chasing assets and returns, but it is scared money - at the first sign of trouble it sells and flies away. Thus, general market swings of +1,000 points and then -1,000 points in the space of perhaps one month have become common place on Wall Street. Investment was not like this in the past. This creates opportunities for the brave investor or trader at high and low points, but can provide a very bumpy ride.

We hope that readers will take heed of these warnings and assess their financial planning from a logical and conservative perspective.

To view other related pages, please visit:

Beginners Guide To The Stock Exchange

Beginners Guide To The Stock Exchange - Part 1

Beginners Guide To The Stock Exchange - Part 2

The Stock Market For Beginners: 7 Starter Tips

How To Start Investing On The Stock Exchange

Peter Lynch And The Ten Bagger

What Is The Stock Market?

Why Should You Start To Invest On The Stock Exchange?

6 Great Ways For Learning About The Stock Market

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