Why Are You Investing?

A frequently asked question about investing is: “What investment should I make?” The truth is for many people this question is premature. This is because we want to immediately get to the endpoint without the painful tedium of answering the questions needed to find the best decision. This article reduces the tedium and helps you to decide if you should be investing in the first place, and if so, sets a course to answer “What investments should I make?”

Motivations

The definition of investing is putting your capital (money or other valuables) at risk in the hope or expectation of receiving some value. Before deciding on how to invest or what investments to make, it may be a good idea to really understand whether it is a good idea to invest at all and if so, being clear on why you are taking the risk.

There are only three basic motivations for you to invest. Only one of these can be primary for a particular investor at a given point in time. While some investors will say that all the motivations apply and others may pick two of the three, only one can be primary. It is this primary motivation that should determine if making an investment is a good idea and guide the way investments are made.

The three motivations are:

You learned that investing is the smart thing to do.

You want to get as rich as possible.

You have one or more specific purposes for your funds.

The first step to successful investing is selecting which of these three motivations is primary for you, the investor. You will set your investment direction by understanding what your primary motivation is. You will learn from this article that each motivation yields a different course so focusing on more than one will lead nowhere.

Recognizing your primary motivation is not easy. The easy answer is wrong. It is wrong to say that you are influenced by all three. While this might be true, it does not help. You might as well choose to go east, west and north at the same time.

Going East

If you invest because you believe it is the smart thing to do, you will have to become a very smart investor. Consider that there are literally millions of ways to invest; they can’t all be smart. You have to be really smart to figure out which are smart and which are not.

Unlike the laws of nature, investments are not predictable. The investments that yielded the best results may never repeat that performance. Other investments that were disappointing in the past may turn out to be big winners. Investments with no past record could go either way. There is no formula that can always select the smartest investment.

If your motivation to invest is that you think it is smart, you need to find just which investments are smart. This is best done by learning from the smart people who have a superior method of picking winners. If you are convinced that some expert can give you a better chance of picking winners, then by all means follow their advice. If you can’t find such an expert then you should reconsider if investing is really such a smart idea for you and consider making another motivation primary.

Most people will find that investing simply because investing is a good idea is a bad idea. The search for an inherently good investment is perpetual. The best outcome is for your investments to be successful more often than they fail.

Going West

When your primary motivation is to become as rich as possible, you must come to terms with the possibility that trying to reach the maximum wealth you are likely to be taking the greatest risk. This risk can go beyond the capital you invest and include all that you own and compromise your family and your future earnings.

Most people are unwilling to take the chance of losing all they currently own and that which they may own in the future. They are willing to limit the potential wealth to avoid such extreme risks.

Moderating the risks involves determining how much loss you are willing to suffer in the pursuit of wealth. While this is not an exact science, likelihood of loss can be estimated for most investments. You can then find investments that are consistent with your tolerance for loss.

The process of determining your tolerance and finding appropriate investments can be done through tools available to investors or to their advisors. While no endorsement is made, online tools are available at University of Missouri, CalcXML, The Motley Fool, Bankrate at no charge.

While these results can provide a starting point, circumstances are constantly changing. Your tolerance changes with your personal situation — getting married, having children, divorce, getting a new job, increased wealth, losing a job, losing money, retirement, growing old, poor health, etc. With all of these changes, your tolerance for loss changes and you may need to change your investments.

Additionally, the likelihood of loss of your investments also changes. Businesses, governments and other institutions are in a constant state of flux resulting in changes in this likelihood.

Recognizing these changes is critical to keeping your investments aligned with your personal situation. It is essential to continually reassess your tolerance and the investments you have.

Going North

If you have one or more specific purposes in mind, you need not invest if you have sufficient funds available. If you already have sufficient funds to pay for what you have in mind, there is no reason to take additional risk. In this case, you need to preserve or use the funds you have to be sure that there won’t be investment losses.

The only reason to take a risk is if you are or expect to be short of the funds you need for each purpose you have. For example, if your goal is to buy a home that requires a $100,000 down payment and you only have $75,000, you can try to make up the difference by investing. You must recognize that in pursuing the $100,000 target you could also lose some of the $75,000. Additionally, there is no assurance when or if the $100,000 will ever be achieved.

The strategy of investing only as much as is needed to fund a specific purpose is one that has been used for decades by large institutional investors. The term for this strategy is “Liability Driven Investing” (LDI). The institution determines how much money will be needed at some future date (their liability) and if that money will be available, no investment is made. Instead the funds are preserved “risk-free” until it is needed.

LDI has been adapted for individual investors in a strategy called “Purpose Based Asset Management” (PBAM). The PBAM process involves three steps for each purpose that you have:

Identify the purpose, time frame and funding requirement.

Determine the sources and whether available funds are sufficient.

Select investment that can reasonably be expected to produce required funding.

Purposes

The first purpose selected is the most important, followed by the next most important until capital is exhausted.

The table below shows typical purposes for investment funds:

Sources

Capital required is allocated and if sufficient it is preserved in risk-free or low-risk holdings.

Sources of this capital include:

Selecting Investments

Investments for each purpose are selected based on the likelihood of producing the returns needed to fund that purpose in the time frame required.

The major providers of investments and investment advice offer help with investment selection. You can decide whether you would like to undertake this selection on your own or use the help provided by the firm of your choice.

Conclusion

A prudent investing process as described here is overwhelming for most people, so this article is not intended to make you an expert at managing your finances.

The goal of the article is to guide you to the areas of investigation and to ask the questions that need to be answered. Whether you choose to do it yourself, use a computer guided approach or turn to a personal advisor, you will know what should be covered.

Louis S. Harvey, President and CEO. Founder and leader of DALBAR. He can be contacted at lharvey@dalbar.com.