Why investors invest

What motivates a person or an organization to buy securities, rather than spending their money immediately?

People invest to earn a return. Some people invest in insured savings accounts or certificates of deposit; some invest in currencies, stocks, Bonds or mutual funds; some invest in options and commodities. For the investor, the fundamental difference between these types of investments is the risk they entail and the return they are expected to generate.

The most common answer is the desire to preserve capital. An investor with the objective to preserve capital would not be willing to invest a lot in currencies or stocks. The other goal of people is the desire to increase wealth, known as capital appreciation. Investors seek appreciation for a variety of needs: retirement funding, college tuition, travel, a vacation home. The most common growth oriented investments are common stock and stock mutual funds. People and organizations anticipate future cash needs, and expect that their earnings in the future will not meet those needs. Many investors particularly retirees and others on fixed income want to generate additional current income from their investments.

Corporate bonds, Municipal bonds, government and agency securities, preferred stock, money market funds, and fixed and variable annuities are among investments that can contribute income through dividend or interest payments. Tax advantage is one reason why some invest. Annuities and traditional IRA’s allow interest to accumulate tax deferred until the investor withdraws from the account.

Portfolio diversification is an important goal in order to increase returns and lower risks as concentration of investments expose individuals to lower returns and higher risk. Some people want immediate access to their money at all times.

Though stocks and bonds have ready markets for their sale and purchase, they offer varying degrees of Liquidity. A product is considered liquid if it can be sold quickly at face amount or at a fair market price with out loss of principal. Among an individual’s investment objectives might be the need or desire to speculate on higher than average returns in exchange for higher than average risks. Speculation is a legitimate investment objective and many individuals would be well advised to place at least some portion of their investible assets in speculative high potential-return investment and securities. Another motivation is savings -- the desire to pass money from the present into the future.

One other class of investors significant in the economy are financial institutions and banks or other financing operations in the economy. This is the class of risk neutral investors who can be identified by utility functions of the linear form. Whether measured as a proportion of wealth or as an absolute amount of money at risk, such investors do not demand better than even odds when considering risky investments.

Setting Investment Objectives

This section is the part where you write down what it is you want in your life. Each individual and family is unique. Therefore, the specific goals you want to achieve in your life are unique to you. However, there are some specific goals, which apply to just about everyone. These are the ones we deal with here. Your list will probably be more detailed and longer. However, this is a good start.

The first thing one has to do is to protect them against risk. This is done two ways. The first is to create an emergency fund. The emergency fund will protect the individual or family against unexpected situations. These unexpected situations might be unemployment, health care costs not covered by insurance, or property losses not covered by insurance. The second thing to do is to purchase adequate insurance. The best mix of insurance will cover: disability, health, life, property and casualty, and your automobile.

The next thing is to provide for the financial security of yourself and your family. Many people have other dependents like elderly parents they have to take care of. As time passes, many people want to be able to fund in part or in full the tuition needs of their children and special things for their children such as first homes, cars, etc.

Another goal many people have is a comfortable standard of living. By this, we mean travel, vacations, relaxation, a second home, membership in a country club, entertainment, a new home or improvements to your existing home etc.

A fourth goal almost all people have is a comfortable retirement. People want to maintain the same standard of living in retirement that they had while they were working. They want to maintain their financial independence during retirement and if possible retire early. It is also important to shield your assets in retirement against a medical emergency.

The last goal most people have is estate planning. Regardless of circumstances, almost all people want to provide for an orderly transition of their assets. The fallacy is that only people with large estates need to plan. The reality is that almost all people need some type of estate planning.

It's not enough to establish these broad goals without specific time frames, amounts, and other details. For instance, with regard to the emergency fund, one would want to put down how much money to put into it and when it will be fully funded (e.g. I'll establish an emergency fund with $15,000 in it two years from now.

Factors to consider for your investment objective

Time horizon

Investors need to know the time horizon available to reach their investment goal, be it retirement, saving for college or a house, or something else. In other words, you should calculate the amount of time you have to get from point A to point B. You should also examine how quickly you will spend your accumulated wealth once you reach your goal. As an example, many people can expect to live 20, 30, even 40 years beyond retirement age. This means most people will continue investing during retirement and this should be factored into their time horizon assessment. The more time you have to achieve your goals, the more time you have to save and ride out adverse conditions. Time horizons also influence your portfolio choices.

A goal that takes 20 years or longer to achieve can permit different investments than a goal with only three years to achieve. Longer time horizons allow you to consider asset classes with higher return potential, but which may carry more risk in the form of volatility. Shorter time horizons usually necessitate lower-risk asset classes that may have more limited return potential.

Risk tolerance

Next; make an assessment of your personal risk tolerance. This can be difficult, but answering a few questions can help.

• How knowledgeable are you about investing?
• Do you have a good understanding of the markets?
• Are you a new investor or have you been investing for many years?
• What types of investments have you made up to this point?

Examining what concerns you most about investing can also shed light on your risk tolerance.

• Are you most concerned about your portfolio losing value? In other words, is preservation of capital most important to you as an investor?
• Are you most concerned that your portfolio gains value? Or said another way, is appreciation of capital most important?
• Are you equally concerned with these two things?

Finally, put yourself in some "what if" scenarios and think about how you might react (be honest!).

• If you lost 10 percent, 20 percent, 30 percent or even 40 percent of your investment, how would you feel?
• At what point would you be in beyond your comfort level and decide to terminate?
• If you've done some investing in the past, how did you react in such situations? Did you sit tight and think long term or did you exit and liquidate?
• What did you do in when the market turned against you?

Expected returns

The third step in the investor profile process is to evaluate your expected returns. What rate of return would you like to achieve in your portfolio? Remember, higher returns usually mean higher risk—odds are you will not be able to design a portfolio that achieves 100 percent returns each year and still matches your personal risk tolerance. You should also consider what rate of return you need to achieve in order to reach your investment goals within your time horizon.

Investment vehicles

Here, you want to assess your understanding of and exposure to the various Investment vehicles. You should also examine any individual preferences or restrictions you may place on your portfolio. Answering a few questions will help clarify these issues.

• Do you understand the distinguishing traits of the different investment vehicles?
• Are you familiar with their risk/return characteristics?
• What is your investing experience among the different investment vehicles? Have you been exposed to only one area?
• If you currently own investments, which are the vehicles you have used?
• Lastly, do you have particular preferences or restrictions?

Tax status

Finally, we come to the last step in the investor profile process, tax status. Two factors should be considered here.

• In which combined (federal, state and local) tax bracket are you?
• Will you be investing in tax-deferred or taxable accounts (or both)?

Finding out your nett worth

There are two financial stages in a person’s life:

• The first stage is the accumulation period.
• The second stage is the distribution period, which comes at retirement.

All the writing in this section and the following sections is relevant to the accumulation stage.

People who are accumulating assets are also broken down into other stages of their life. That is, are you single, married, divorced, have children, etc.? What is your career? When one chooses a career path, to some extent your earning potential is somewhat determined. For instance, a teacher, a doctor, an engineer, and a computer programmer, are all going to have different limits on their earning potential. Are you the type of person who seeks immediate or deferred gratification in your spending habits? Do you live for today or plan for tomorrow? And what do you spend your money on? Do you want a newer and bigger home or a vacation home? These are all factors, which play a role in your lifestyle.

Lifestyle decisions are personal decisions. They are yours alone. They involve confidence, or lack of confidence in the future. How you spend your money is your business. The main thing is to know yourself and not try to fit into another person’s idea of how you should live your life. What is important, however, is not how you spend your money, but rather, how you allocate your money.

The first step in this process is to figure out your net worth:

To do this, a net worth Worksheet should be used. This net worth Worksheet will be used to list all your assets and liabilities. You will then be able to calculate how much you're worth. The net worth Worksheet is a crucial step in constructing a good financial plan. You must know all of your financial resources and how you have allocated them.

People tend to accumulate assets in a couple of places. And this may not be the best way to allocate your resources. People can usually tell you all kinds of minuscule facts about themselves and their families. However, ask them what their net worth is, and they can only give you a 'ballpark' figure. And usually, they're not very close.

The second step in creating your financial profile is to determine your cash flow. To do this, we use a Cash Flow Worksheet. The purpose of this Cash Flow Worksheet is to determine where your money is going and to see if you're running at a surplus or a deficit. You will then be able to see how much money is available to reach your financial goals.

One thing that many people have found handy in determining their every day type of expenses is to keep a journal and use it to record all expenses on a daily basis like dry cleaning, laundry, lunch, taxi's, tips and all those other 'little' expenses. These 'little' expenses add up to a considerable amount over the course of a year. Most people are quite surprised at how much they actually spend on these things.