Category: Financial Resources

Welcome back to our exploration of the ten core principles of investing. In Part 1, we covered the foundational strategies every savvy investor should know, from diversification to skeptical evaluation of too-good-to-be-true deals. Now, in Part 2, we’ll delve into the remaining principles of investing to enhance your financial acumen further.

In this segment, we’ll explore balancing risk and reward to optimize your portfolio, the critical importance of planning your investments, and adopting an endowment mindset to think like a seasoned investor. We’ll also discuss understanding the true ownership of your investments and why a single observation doesn’t constitute proof in the financial world.

Let’s continue our journey to mastering the principles of investing and building a robust strategy that stands the test of time.

Principle #6: The Balance of Risk and Reward

In any investment, there is risk. A person might argue, “Well, that isn’t true for an envelope of cash that I have at home,” but even that is subject to theft, misplacement, or, at a minimum, a loss of 1% to 2% a year based on inflation. The critical point of this principle, however, is that there is always a relationship between risk and reward. The greater the reward, the higher the risk.

The graphic related to this post shows three example returns. The bottom line is conservative, and the top line is open market and aggressive. The general trend is up in all of them, but the amount of ‘ups and downs’ or volatility in the example increases with the reward level.

This is true of all investments. The higher the reward, the higher the risk. If there is low risk, then the reward will also be low. If at any time someone tells you that this isn’t true for their investment— that somehow they have magically created great reward with minimal risk—then something is wrong.

Types of Risk

Also, note that risk comes in many forms. A common risk not normally considered is ‘opportunity risk.’ This risk means, ‘ If I do this, then I can’t do that.’ A good simple example is a savings deposit at the bank. In a general savings account, I can move money in and out as I wish, but the interest rate is very low—generally less than 1/2 percent.

If I put that money in a CD (certificate of deposit), then I can get perhaps a 2% return, but I can’t touch it for a year (until the CD expires). That’s opportunity risk. I have a higher reward, but I risk losing access to my money for some time.

There is always a balance between risk and reward.

Principle #7: Fail to Plan – Plan to Fail

This principle is crucial for your own protection. If you read through the three scenarios I shared in Part 1, you will have noted that each had some money, knew it needed to be invested, and wanted to be smart about what they were doing but ultimately didn’t accomplish their objective.

The first question you must ask yourself regarding an investment is, “Why are you investing?” No—really. What do you want this money that you are putting aside to do? Is it retirement money? Is it rainy day money? Or is it for a big vacation you hope to take three years from now?

The answer to those questions frames the investment structure. Planning means you must think about the what and the why and then add the duration you must operate in. That may sound a little confusing, but think about it this way: money you save for a rainy day in an unknown time horizon would be invested differently than for retirement, where you don’t expect to touch it for ten years.

Don’t get swept away by how good something sounds; start with your plan first. Why are you investing? What do you need the money to do, and in what time frame? With that plan in mind, you’ll always make better decisions.

Principle #8: The Endowment Mindset

Nearly all large charitable or educational institutions in the US and Canada have large-scale endowments. An endowment is a pool of investment resources that have generally been gifted “endowed” to them or are built from the contributions of the firms’ members. These funds are intended to support some long-term goals and higher purposes requiring careful consideration. Endowments are used for things like the expansion, care, and maintenance of buildings, the funding of programs and research, or sometimes the retirement needs of the contributing members.

These endowments are enormous, often in the billions of dollars. Some of the most well-known endowment funds are associated with prestigious universities. As of the date of this writing, Harvard’s endowment is $50.9 billion, Yale’s is $41.4 billion, Stanford’s is $36.3 billion, and Princeton’s is $35.1 billion.

Applying an Endowment Mindset

Now, let’s say that you’ve been placed in charge of one of those multi-billion dollar accounts that are supposed to be active and growing for decades and that thousands of people depend upon you and the decisions you’ll make regarding how that fund is invested. Would you invest it in something your uncle told you about? Or a tip you heard from a friend of a friend? Or buy an annuity policy from the fellow down the street that your dad knew? Of course not. You’d research thoroughly. Thinking long-term would be essential. You’d have a professional working with you, and together, you’d counsel to make the best decisions possible. Ensuring that whatever decision was made would be in the fund’s best interest and aligned with your objectives for that fund would be a priority.

You should invest your own money that way. An endowment mindset involves using a ‘risk matrix’ approach where the mix of investments in the fund manages the fund’s risk. It means investing a significant portion of the fund in asset-backed alternatives, indexed bonds or structured notes, and real estate rather than straight stocks or mutual funds. This mindset also entails starting each placement with the long-term objective of the fund in mind rather than focusing on individual investments.  What does the fund need?  Does this investment contribute to that objective?

Principle #9 – Whose Money is it?

In the investment world, there are three types or categories of investments. Those are: 1) loans, 2) assets, and 3) products. These three types have many options, but each investment will fall into a specific category and then branch from there.

The First Category

A loan is different than you think because you are the lender, not the borrower. A loan is a savings account or certificate of deposit (CD) at the bank or credit union. You are giving your money to the bank. They will use your money to help other people and pay you some interest for using your money. So, in this case, you loaned your money to the bank, and they are making payments to you in the form of interest.  In this category, the money is still your money. You decided where it would go, agreed on the amount you would be paid, and you can pull it back as you see fit.

In some cases, like with a CD, the bank may pay you a higher interest rate if you let them put some time constraints on the money. That gives them more flexibility in using the money because they know you won’t ask for it to be returned until a specific time. But it’s still your money, and you have control over it. A bond is also a loan. You give a specific amount of money, and the borrower (the bond issuer) commits to a certain amount of return.

The Second Category

An asset is something of tangible value that you purchase. The value of your purchase may vary depending on a wide array of factors. A stock is an asset. A stock is a share in a company or property. Stocks are known as equities; you have potential equity in your purchase that may be greater than your initial investment. A mutual fund is a collection of stocks. An ETF is a collection of stocks. These are assets. You own something, and that something will become more valuable or less valuable over time. An asset is your money. You can decide what to do with it. Sometimes, fees are associated with when and how you purchase or sell the asset, but it is still your money.

The Third Category

The most common products in the investment space are annuities and certain life insurance policies with associated investment elements. It is essential to know that when you buy a product, you purchase an outcome or service, and it is no longer your money. You own a product, not the money. The product you purchased may have value and can be canceled (sometimes with penalties) or resold at a loss, but the money itself is no longer yours. You bought a product. 

Let’s use an annuity as an example. Jill had a $50,000 inheritance. She decided to purchase an annuity. The insurance or investment company determined that if Jill gave the $50,000 to them and didn’t cancel the product for ten years, they would pay her $500 a month once she turned 65 every month until she died. Let’s say that two years into the program, something happens where Jill needs $20,000 of that $50,000. Can she get it? Is it her money? The product that she purchased was a payment stream in the future. It’s no longer her money. The insurance company began working with the money she submitted to them to prepare for that payment stream. She can cancel the product and get a reduced value back, but penalties will be associated with that cancellation and return.

The point of this principle – Whose money is it? – You must be aware of the investment category you are involved with. Loans, assets, and products each have unique benefits and restrictions. What was great for Jill might be a terrible decision for Sandra. Your needs, objectives, and goals matter and should be the first point of consideration when deciding the type and structure of your investment portfolio.

Principle #10: A Fact-Based on an Observation of One is Not Meaningful

There is a fascinating marketing and decision science discipline called ‘Choice Architecture.’ This discipline affects your life daily and most often does so without us knowing it’s happening. Choice Architecture is the study of how the presentation or the sequence of things can manipulate our decisions. Choice Architecture is why healthy items are placed at the beginning of the cafeteria line and why the price of something impacts our view of an item’s quality. In these examples, the choices and our perception of them are manipulated intentionally to change how we feel about them.

We often do this unintentionally to ourselves through overreaction, jumping to conclusions, or allowing ourselves to be led down a particular path. This is especially true in the world of finance and investment. One of the most common culprits is our assumption of ‘fact based on an observation of one.’ Making assumptions from a single observation is a dangerous habit that almost always leads to disappointing results or reliance upon something untrue. We must also recognize that past performance is not an indicator of future performance.  Each investment must be researched and considered on its own merits.

Whenever you are faced with a statement of “fact,” be sure to ask yourself how to validate that the statement is true. Question actively. Research to see if there are other views, positions, or possibilities. Make decisions based on multiple facts and observations – not just one. Fully understand the pros and cons of a given thing and expect the same from advisors you’ve hired to help you. Make sure that you are investing rather than speculating. Never make decisions based on a ‘fact from an observation of one.’

Solidifying Your Investment Strategy

As we reach the final principle in our exploration of the core principles of investing, it’s crucial to remember that these guidelines form the foundation of successful investment strategies. By adhering to these principles of investing, you can make informed decisions that align with your long-term financial goals.

Key Takeaways

As we wrap up Part 2 of our series on the ten core principles of investing, we hope these final five principles have given you a deeper understanding and equipped you with the tools to make more informed decisions.

By integrating these principles of investing into your strategy, you are well on your way to becoming a more thoughtful and more confident investor. But remember, the investing world can be complex, and having a trusted advisor can make all the difference.

If you need personalized guidance or have any questions on the principles of investing, our expert financial advisors are here to help. Contact us today to start your journey towards smarter investing and secure a prosperous financial future!