This is a follow-up of my article titled "The Importance of Financial Education" which appeared in the FE last week (Wednesday, May 15; page 6).
Broadly, there are three types of investors - strategic buy and hold; and traders. Sponsors and institutional investors acquire, or hold onto, a certain percentage of ownership for strategic reasons. Changes in portfolio value or earnings from year-to-year do not affect their outlook. The stocks outside this restricted orbit are available for trading hence known as free float.
Those who buy and hold for the long term are known as portfolio investors. Either individuals or institutions, they painstakingly build diversified and balanced portfolios in order to build their wealth or endowments. This group develops a close relationship with their brokers for research and trade execution. They do not have a sentimental attachment to any particular investee.
The last category, traders, engages in fishing expeditions to wring out the maximum short-term profits. This group reacts quickly to every twist and turn in the market and often engage in risky bets.
Share prices react to news and the actions of market players. Prices of securities move in a random or unpredictable fashion because the stimuli are unknown. Although fundamental analysis gets a lot of importance, past performance is no guarantee of the future. When share prices go up this results in capital gains and ultimately translates into superior total returns. It may therefore be disappointing when a particular share price nosedives just when you plan to exit.
Events that can make a difference in investment decisions are known as market signals. Without apparent rhyme or reason, a particular signal may give rise to a certain attitude-positive or negative; we may call them market sentiments. A herd mentality may develop giving rise to unfounded fear, a powerful motivator. Rumors, planted or otherwise, may spread giving investors a panic attack.
Prominent among market signals are earnings and dividends declarations, block trade, unusual price movements, a change in classification (e.g., A to Z category), supply shocks, stricter regulations, imposition of tariffs, and investigation by regulators. Interestingly, information of a pure financial nature hardly features above.
Portfolio investors are well-advised to prepare an investment policy statement (IPS) at the very outset. Carefully crafted, this document serves as the north star of the investing process and is referred to time and again. Inter alia, IPS (investment policy statement) lays down such aspects as the stock selection process, periodic review, diversification, target amount, time horizon, rebalancing and risk appetite. It is easy to fathom why, without the IPS, one would feel rudderless in a dynamic environment.
Ideally, the risk complexion of a portfolio should change with time becoming more and more conservative. A young person can afford to lose money because he has time on his side. Not true for a middle-aged or elderly person. There is no harm if the portfolio is mainly composed of risky assets at the early stages. With the passage of time relatively safer fixed-income securities should supplant stocks. I refer to such assets as Sanchayapatras, bonds and term deposits. It is best for elderly individuals to come out of stocks entirely by the age of, say, 70. At this stage one just gnaws away at the basket of assets; there is no scope to build anew.
Rebalancing needs especial mention. Because of price increases and/or dividend re-investment the value of the portfolio may temporarily be weighted towards one or two stocks. A shortsighted investor may fall for a couple of inflated stocks to the detriment of diversification, a cornerstone of investing. IPS, reviewed semi-annually, helps correct such biases.
Raihan Amin is Trainer Bdjobs.com