Hurdle 1: Risk Appetite
Investing simply isn’t for everyone.
- Even if equities have delivered strong returns over both the medium and long term.
- Even if an effective investment portfolio could grow savings faster.
- Even if this meant that you could retire earlier.
This still doesn’t mean that everyone should invest in the stock market.
The reason why is risk tolerance. Tolerance to risk varies dramatically from person to person.
Risk tolerance isn’t a static personal trait either; it can change with age. As we move through life, our circumstances and experiences also shape our attitude to risk.
Perhaps when we were 25, and our whole life was ahead of us, we were prepared to risk losing capital when investing because we were confident that we could earn it back.
Once 50, with a significantly larger pot of savings, and an upcoming retirement, the risk of suffering a sharp drop in wealth begins to feel more threatening. At this stage in life, a sharp crash could require you to cancel retirement plans.
Risk appetite is a key hurdle that any potential investor should consider before spending a penny buying shares. If you invest with incompatible risk tolerance, you could experience:
- Persistent anxiety about the performance of your shares
- The need to constantly check on their performance
- Deep regret or emotional distress during market turmoil.
All of this is completely avoidable, by not investing at all. Any investing course worth its salt will ensure that ‘not investing’ is an option taken seriously by all potential investors.
The symptoms above are not typical of all investors. Many, myself included, can take larger risks with investments and lose no sleep over it whatsoever. Don’t feel like you need to ‘force yourself’ into investing, or ‘face a fear’ by doing so.
The objective of investing is to unlock prosperity and enhance your quality of life – not diminish it.
Hurdle 2: Time Horizon
If your appetite for risk is at a comfortable level, you should still consider your practical circumstances carefully before investing.
Most investments, such as corporate bonds, equities and property are designed to be held for a long period.
They typically have transaction costs – fees to enter or exit the investment – which makes a short term position prohibitively costly.
They can also have serious restrictions on access. Some property investments, for example, may not be liquidated for five years after investment.
But the largest factor of all is the volatility of returns. Stocks and shares might promise healthy returns on paper, but this number is usually based upon a long term average. Over the short term, the investment may perform dramatically differently and even generate a loss.
You can only confidently expect to receive healthy returns if you are also committed to holding the investment over a similarly lengthy period. Any shorter, and you run the risk of being caught out by the short term fluctuations in the market.
The general guidance is that you should not invest in the stock market unless you plan to hold that investment for 5 years. For other investments, you should consult the terms and conditions to understand:
- If there are withdrawal restrictions which will restrict withdrawals until a later date
- Over what length of time, their average historical return was calculated
But either way, 5+ years work as a reasonable starting point. If you’re only saving money for 2-3 years, then I’d strongly caution against investing your money in the stock market. I’d suggest savings options with lower risk and volatility such as savings bonds instead.
Another thing to think about with regards to the time horizon is the fact that even solid plans can change, particularly when thinking about such a long term period. In 10 years, for example, relationships can break down, loved ones can be born, or lost, and our living situation could change dramatically.
And yet, the textbooks ask us to only commit to an investment in the stock market if we can be sure that we do not need the money for 10 years. How can we do this? Surely nobody can be absolutely sure of this?
Well, indeed nobody can be 100% sure. All we can do is look at the different scenarios which could occur in the next few years and consider whether any of these are likely, and if they were to occur, would they actually require us to withdraw money from the stock market?
You’re entitled to consider that you will be earning an income over this period, therefore if this income is also being put into a savings accounts and keeping an emergency fund topped up, then you could feasibly rely on this pot of money if your circumstances change, rather than needing to sell investments and possibly trigger a loss if the stock market was in a slump.
You can never be certain, and you don’t need to be a soothsayer, it just takes a bit of deliberate thought to check that you are not in a position where any likely change in events would require you to change your plans dramatically.