Investors who have been withholding their cash from the market or those who have recently had a liquidity event and are seeking to make substantial investments for the first time may have some things in common regarding investing readiness — or lack thereof. Not only might they lack a sound investment methodology, they also might not have any personal context for determining one.
These investors would be more likely to succeed if they followed these five steps.
1. Assess your tolerance for investment risk. This may be much tougher than you think. Many believe they have a high investment risk tolerance, until they experience significant losses and the despondency that ensues. Many advisors have questionnaires for clients aimed at determining their tolerance. Sometimes, to answer these questions honestly, clients need to undertake considerable reflection.
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2. Determine your financial capacity for risk. How much risk you can afford to take with your investment portfolio during retirement, or when approaching it, depends on your cash flow from available income streams — such as pensions, Social Security benefits or annuities — and doing a thorough cash-flow analysis is paramount. If you're depending on your portfolio to throw off a certain amount of cash and you take too much risk by choosing investments that are too volatile, you could come up short regarding your living expenses and be forced to accelerate withdrawals, increasing the chances that you'll run out of money or shortchange your estate.
3. Identify market sectors that are currently viable relative to where the economy is in the business cycle. For example, contracting economies mean investing in safe, defensive sectors, such as consumer staples (people brush their teeth in all cycles) and utilities. In a developing economic expansion, people spend more, so consumer discretionary companies such as entertainment enterprises tend to do well. In the later stages of an expansion — where we are now — basic materials are a good play, as are financials in this rising interest-rate environment, which creates lucrative spreads for banks and financial services companies.
4. Identify generally promising-looking companies within these sectors, and evaluate them as portfolio candidates based on earnings momentum and intrinsic value. Many investors make the mistake of looking only at current or recent earnings, which are nothing more than meaningless snapshots of where a company is or was. Instead, use earnings momentum to see where earnings are headed — up or down.