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Seven Investment Principles You Should Know

Seven Investment Principles

Firstly a point to note that the information within this article is opinion only and is not offered in any way as guidance or advice. There are lots of factors to consider when investing and points below are not exhaustive.

When investing you should always consider seeking professional advice from a suitably qualified and competent financial adviser who understands your individual needs and circumstances. The points in this article are opinion only and are not offered as guidance or advice.

10Expert.com accepts no liability for any inaccuracies in any material or information in this article. 10Expert.com does not provide advice, endorsement or recommendation for any product or service.

Seven investment principles you should know all made beautifully simple!

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1. Time Horizon

Time horizon is the amount of time an investor can invest funds without needing to liquidate this to release cash.

Time horizon is important when investing as it’s closely connected with ability to accept investment risk and capacity for loss. For a low time horizon such as twelve months there is very low capacity for loss. This is because there is limited time to ride out any volatility in an investments value and so limited capacity to take on investment risk.

For example when holding cash for a property purchase in three months’ time there is virtually no capacity for loss. This is because there is very limited time to ride out any volatility in the markets and any investment losses could jeopardise property purchase entirely.

For short time horizons holdings funds so that they are not exposed to investment risk, such as in a bank account may be sensible. Accepting in this situation that the return is likely to be negligible for the short period of time the funds are there. Do note however that even bank accounts have their own risks such as inflation and interest rate risk.

Market backed investments are more appropriate for longer time horizons of at least five to ten years plus. This is because the longer time horizon provides more opportunity for growth and greater potential to ride out any short-term volatility.

Investing over the longer term can provide greater “potential” of a positive outcome but there are no guarantees when it comes to investing. Past performance is not a guarantee of future returns.

In terms of time horizons there is no hard and fast rule to quantify these but short term is often regarded as less than five years. Medium term five to ten years, and longer term could be ten years plus. This isn’t an exact science and classifications of time horizons do vary.

When investing you should always consider seeking professional advice from a suitably qualified and competent financial adviser who understands your individual needs and circumstances.

2. Capacity for Loss

Capacity for loss is a measure of an individual’s ability to absorb investment losses without their standard of living being adversely impacted.

An example of very low capacity for loss could be someone in poor health, with a low income and who is dependent on their capital to maintain their standard of living. In this situation investment losses could likely have a severe impact on the individual.

Where an individual is in good health and has no current or foreseeable need to access funds in the short or medium term and has significant other assets and income, such an individual would have a higher capacity for loss than in the previous example. This is because any investment loss would be unlikely to impact their standard of living.

Lots of factors impact on capacity for loss such as level of wealth, health, time horizon, income/expenditure and more.

It is also worth noting that capacity for loss is only one measure of risk. An individual with a high capacity for loss may also have a very low attitude to risk meaning that investing could still be inappropriate.

When investing you should always consider seeking professional advice from a suitably qualified and competent financial adviser who understands your individual needs and circumstances.

3. Attitude to Risk

Attitude to risk is an attempt to quantify an individual’s unique perspective on investment risk. It’s less based on facts and more a subjective assessment of what level of risk someone is comfortable with.

Often risk questionnaires are used by investment providers to evaluate an individual’s attitude to risk. These risk assessments can be subjective as question responses will likely be influenced by things such as past experiences and current perception of the markets.

As with capacity for loss attitude to risk is only one factor when investing. An individual could have a high attitude to risk but may equally have a low capacity for loss. All factors need to be considered together and seeking professional advice should be always be considered.

4. Diversification

Diversification is an investment risk management technique whereby risk and return can be optimised so that for any given level of risk the optimum mix of different assets are held in one portfolio. Diversification can add value in several ways, firstly it helps protect portfolios from being wiped out by the failure of one company or segment of the economy. This can be achieved by spreading the investment risk across different asset classes, markets and segments.

Secondly diversification can utilise the correlation between different asset classes to manage volatility. By selecting assets which are positively and negatively correlated, investors could achieve some protection against volatility and optimise returns.

Diversification can help to manage risk within an investment but it is important to remember that risk cannot be fully diversified away and that investments will usually always carry some level of risk. Also depending on the financial climate different asset classes may not always interact with each other in the same way and the assumptions within diversification can be wrong.

5. Liquidity

Liquidity is measure of how easily and quickly an asset or investment can be sold and its value released back to cash.

Different assets and investments provide different levels of liquidity and the liquidity of some assets can vary dramatically over time. As an example cash in an instant access bank account would generally be regarded as highly liquid as it’s possible to access the full value immediately.

On the opposite end of the spectrum unlisted shares in a company and property can be highly illiquid due to the limited numbers of buyers in the market and the time and costs associated with sale of such assets.

In the case of property it can take years to negotiate a sale and even where a sale is quickly agreed the legal process can itself take many months to complete. In recent years the liquidity profiles of certain asset classes have displayed significant volatility.

6. Correlation

Correlation is a measure of the degree to which the values of two assets move in relation to each other. Correlation sits on a scale of -1 to +1, with -1 being a complete negative correlation and +1 being a complete positive correlation. A correlation of 0 implies that there is no correlation between two assets.

Correlation can seem rather complex but it really isn’t. Fund managers use statistical analysis of correlation to build portfolio’s that seek to offer optimum returns for each given risk profile, informing decisions on things such as diversification and the overall asset allocation of a portfolio.

Just as with liquidity correlation is fluid and can change between two assets over time. From an investors perspective it’s helpful to understand correlation in theory, if you are interested in learning more then Investopedia have a great article on correlation.

7. Risk v Reward

Risk & reward with investments go hand in hand. The relationship is that typically that investments with low levels of risk will equally offer low potential return. Conversely where investments carry higher risk of loss to capital investors demand higher potential returns to justify taking the increased risk.

All investments carry some level of risk. The general rule is that the higher the risk the higher the potential return. A key point here is the “potential return” element of this equation. Whilst a higher risk investment may offer a higher “potential return” the increased risk makes the outcome less certain so there is also more probability of a negative outcome than with a low risk investment.

You can find an interesting article from the balance on risk & reward here where they probe this issue in detail.

Thank you for Reading

Please share what you think by commenting below and remember to like and share.

Please note that the information within this article is opinion only and is not offered in any way as guidance or advice.

When investing you should always consider seeking professional advice from a suitably qualified and competent financial adviser who understands your individual needs and circumstances. The points in this article are opinion only and are not offered as guidance or advice.

10Expert.com accepts no liability for any inaccuracies in any material or information in this article. 10Expert.com does not provide advice, endorsement or recommendation for any product or service.

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