The Five Steps of Investing Preparation
There are five main steps in selecting various investments to ensure they meet your objectives.
Step 1: Investor Personality Profile
The investor personality profile reflects your personality as it relates to your tolerance for risk, need for liquidity, and the timeline for reaching goals. It is important to balance all four of these considerations to reduce risk, while increasing return. In addition to these, you must consider two other factors that you met previously - inflation and diversification.
Risk is the degree of uncertainty about the expected return from an investment, including the possibility that some or all of the investment may be lost. With some securities (e.g., Canadian Government Treasury Bills), there is very little risk that investors will lose any of their initial investment. With some other securities, the risk of loss can be substantial. Some people can tolerate more risk than others.
We have included 3 quizzes to assist you in determining your tolerance to risk.
Return is the overall profit (after taxes) that you might expect to receive from your investment - either as income, in the form of interest or dividends, or as capital gains (or losses) resulting from changes in the market value of the security. The higher the expected rate of return of a security, the greater the risk. Tax implications are important in planning for maximum returns.
Time frame is the number of years available to invest. For any particular goal, the shorter the time available, the more money must be invested each month.
Liquidity is the ease with which the investment can be turned into cash, at or near the current market price. Some securities, such as mutual funds, offer liquidity by allowing investors to redeem their securities on short notice. Some investors like to be able to get their cash quickly, while others will wait.
It is important to balance all four of these considerations to reduce risk, while increasing return. In addition to these, you must consider two other factors that you met previously - inflation and diversification.
Inflation reduces the purchasing power of money. During inflationary times, the return on investments may not keep pace with the rate of inflation, so purchasing power is decreased. A suggested guideline is to choose investments that yield the inflation rate plus three percent. Promised returns above this amount may carry high risk. Most programs on the Internet will ask you to suggest an anticipated inflation rate.
Diversification is the process of reducing risk by spreading money among various types of investments. Because certain investments perform better than others in certain economic conditions, you can reduce risk by selecting investments with varied risk-return characteristics. Putting money into a variety of investments lessens the risk of loss resulting from any one investment's poor performance.
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