Think of a situation when a stock price drops 5% right after you have purchased it. What will you do? Keep holding?
Then it drops 10% further the next day… what will you do?
Many investors are good at determining when to buy a stock, far fewer know when to sell.
When a holding increases in value it is easy to be greedy and think this trend will continue. Investors may decide to sell a portion of their earnings if the stock goes up say 20%, then a bit more at 40% and so on.
What is Investment Risk?
Investment risk can generally be defined as the possibility or likelihood of getting back less money than you put into an investment. In order to build your wealth and beat the eroding impact of inflation over the long term, you’ll probably need to take some short-term risk along the way. Investors are exposed to the variety of risk includes market risk (including price risk, interest rate risk, currency risk), credit risk, liquidity risk and capital risk. The question is, how much is enough investment risk? How much is too much?
The conflict between your financial and emotional needs.
On one hand, you want to grow your money as quickly as possible because that could help you achieve your goals faster. But because of the greater potential for gain, the greater the potential for loss as well. That is a pain everyone wants to avoid.
So, you have a financial need (to grow your capital) which conflicts with your emotional need (not to worry about your money or financial future).
Most of the time, you probably need both stability and growth. You need security and stability of return over the short term. And you need to grow other money in order to achieve your goals that are long-term to overcome inflation.
If that is true, why not determine how money that is much need for each goal and invest accordingly? That is for me makes more sense. By having money invested correctly and matched to the corresponding financial goal, it helps you stick with your long-term strategy.
Most of the time emotion overtook rational and people who have a strong need for short-term security allow that need to influence long-term investment decisions. When that happens, he might move his long-term investments (that offer the potential for long-term growth) into shorter term investment that solves his emotional need for security. He may end up failing to achieve those long-term goals.Thus, it’s important to recognize the potential conflict and costs if he does that.
This is easy to say and hard to do. Now, let’s consider some way to help you implement this solution.
The Power of Emergency Fund
The first order is to set aside enough cash in liquid, safe bank accounts for short-term needs and unexpected problems. This will help make it easier for you to stick to long-term investing – at least from an emotional standpoint. Why? Because you know that no matter what happens in the market or/and during an emergency, you have enough fund to get if needed. That allows you to relax a bit and focus less on the
short-term performance of long-term investments.
Once you build your emergency and short-term fund, it’s time to set aside money to fund your mid-term and long-term goals.
Having a Diversified Portfolio is Critical
Putting all egg in one basket and selecting the timing of when to sell and take profit can be a difficult decision to make.
Some people like to gain fast so they speculate on what’s going to happen to gold, tech stocks, oil price etc. That often ends up costing investors more compared to conservative investments.
Diversify by spreading your capital across different investments to reduce your overall investment risk. Diversification is a vital strategy for all investors.This practice is designed to help reduce the volatility of your portfolio over time.
It’s true that the past is no guarantee of the future but in order to make a rational decision, you have to use some parameters. The bottom line is, the longer you invest, the more opportunity you have to smooth out returns – to allow the good years to offset any bad years.
What is most important is to achieve your goals. It would be nice if the 20-year sail is as smooth as possible. But what’s most important to you is to achieve your goal 20 years from now. That should be more important than eliminating all short-term volatility.
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