Wealth is an abstract. It is sometimes defined as fecundity or sustainable spending. It is defined as the primary goal for investors and is measured by the level of ‘expendable income’ or ‘capital’ in their portfolio.
Many people define wealth by the total of their assets including real estate, funds, and investments. Others measure it by calculating the amount of money they can afford to spend. Either way, it is important to pick one method of calculating wealth, and stick to it.
How wealth is defined dictates how a person approaches investing. Benjamin Graham states that the investment management is the management of risks, not of returns. This is the foundation of a well-managed precept.
There are several methods of managing risks. Each one provides several benefits, depending on the investor’s aggressive behaviors or willingness to accept high-risk ventures. However, understanding risk can be tricky. One person, such as a broker, may consider a stock that does not perform well as a high-risk stock. A private investor may consider a low-risk stock anything that does not drop below the 10% level.
This is the risk associated with the investor’s personal wealth. What can the investor afford to lose? And, how long can that investor leave their funds untouched? It is also important to calculate how much that investor needs to gain, and in what time span.
Managing Individual Risk
This is easy to calculate in the short term. Just estimate how much money can be comfortably invested. In the long run, it involves a few in-depth calculations. The amount of gains expected, and the impact of failing to meet expectations is a risk that must be written in black and white. When an investor is planning for their retirement, the funds must grow. The rate at which they grow depends on the number of years before retirement.
If the money is not needed, and its loss will not have a major impact on the investor’s wealth, then the investor can look at biotech stocks that may skyrocket if the lab discovers a new drug, or a cure for a disease, or will bottom out if the lab loses their funding.
This is the risk associated with the different markets. Can an investor survive a stock dive, or if the real estate bubble bursts. This will determine whether the investor can manage mutual stocks, or should stick with blue-chip stocks. It will also determine whether the investor purchases a good home in a good neighborhood, expected to appreciate 10% in ten years, or penny stocks that might double in eighteen months.
Managing Market Risk
This risk is associated with the area in which the money is invested. One way to manage this risk is to stay within markets the investor understands. Another way is to avoid buying into both fields. Gold and Real estate are solid, but when they are increasing, stocks decrease, and vice versa. By understanding the risk and expectations in one, two, and five decades, the investor can create a good diversification package.
The first two have statistically-based solutions; increasing risk tolerance addresses an emotional challenge. One way to manage risk tolerance is to minimize the negative impact of the negative risk.
There are two ways to manage risk. First, by building a cushion against risk. Second, by ignoring it.
Education is a wonderful buffer against risk. It is not a magic spell to protect investors from every facing risk and losing money, but the more knowledge an investor has, the less often they will make a poor investment choice.