Wednesday, October 04, 2006

What is my risk tolerance and investing style

What is my risk tolerance? What is my investing style?

This question leads us to selecting individual investments. Consider your investment timetable for when you’ll need the money, recognizing that more conservative selections should be made the shorter the window. Everyone’s risk tolerance is different; while one person may feel comfortable with small-cap biotechs another may need a blue chip to feel equally sound.

Analyzing the risk to reward ratio here is a good first step. The more risk you take on, the more you should expect to get in return if your investment pays off. The inverse is also true: the more stable an investment, the less return one should expect. Government-backed I Bonds pay over 6%, but involve tying up money for years in order to fully benefit from them. While this gives you one target, the average return of the broader market indices is about 11% per year. There are two primary schools of thought about investing: growth and value.

Growth

Growth investing is a higher-risk strategy which focuses on finding smaller companies poised to rapidly grow earnings. Stocks here tend to be micro-caps or small-caps, and the occasional mid-cap (under $10 billion). In their younger lives, many of the well-established companies of today found themselves considered here (Think of Apple Computers (AAPL) or Starbucks (SBUX)). Growth companies can be found in many different sectors, although such companies often have similar traits. A growth company usually has a unique product or service to offer which can fundamentally change how business is done. When found early enough in their growth cycles, these companies have the potential to return enormous profits to investors.

Value

Value plays usually are found in larger companies, although the strategies used to find them can be applied to smaller corporations as well. Looking for value stocks is similar to looking for values in a store: find a good product at a price below what you would normally expect to pay. These bargains are often found in the form of companies which have been unfairly beaten down through overselling. Finding value stocks usually involves using a discounted cash flow model (DCF) to find a company’s intrinsic value. This is the form of investing advocated by Benjamin Graham, and popularized by Warren Buffett.

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