The Goal of Investing

Investing Is More Than Seeking Capital Appreciation

We usually think if investing as seeking a profit on our money over time, a profit that we deem suitable, based upon our goals and our risk tolerance. There are actually two separate goals built into this, which is seeking to maximize returns while minimizing risk.

Often times, return and risk are inversely related, where if you seek a higher rate of return you have to take on additional risk, and if you reduce the risk you will be also reducing potential return.

If you keep your money under the mattress for instance, there is no potential return here as the best you can hope for is to retain your principal. If someone steals it or your house burns down, you risk losing it all, so in this case you have no potential return and some risk, although this would be a fairly low risk investment as the chance of your losing your money would be pretty low.

The Goal of InvestingOn the opposite end of the spectrum, let’s suppose that we put all of our money in a highly leveraged position in a cryptocurrency, which is very volatile by itself and it is leveraged 100:1. If we run well, we can turn our investment into a fortune, where for instance the price doubles and we now have 100 times our investment. This can happen over a period of weeks or even days, so we’re shooting for some pretty impressive returns indeed here.

However, as we enter the trade, if it doesn’t move in our favor right off the bat, we will lose all of our money, because we can’t handle even a small move against us without wiping out our position. With this much leverage, a 1% move will take us out completely, because 1 multiplied by 100 is 100%.

Even a trade like this can be manageable if we do indeed manage the risk properly, even though trading with this much leverage takes great skill. We won’t be shooting to double the nominal price or anything close to it, as we’re going to have to have our finger on the trigger the whole time that we’re in the trade, being ready to exit it at the slightest sign of trouble. We may let the trade run if it starts out well, but we’re still going to need some very strict controls due to how much the results are magnified, to protect our profits and prevent our dropping back into the red.

Both of these scenarios are way too extreme for investors to even contemplate, but in order to give us the best chance to succeed, we need to open our minds and seek out an appropriate balance between these two objectives, risk and return.

Protecting Our Money is the Most Important Thing in Investing

If we take the view that managing risk is the most important thing in investing, this might lead us to think that we should be more conservative with our investments than the norm perhaps, maybe even keeping our money in the bank and not risk losing our capital at all, at least from movements downward.

Even when we do this, inflation will be beating us down each year and our real rate of return will be a negative one and a significantly negative one at that. Money depreciates all by itself and when it doesn’t, governments panic and will spend almost any amount of money to stave off a recession, which is what we call a situation where money does not depreciate in value.

We saw this with the financial crisis of 2007, with all that bailout money paid out to prevent a significant slowdown in the economy. We did see such a slowdown, but governments acted quickly to minimize this.

We can’t just pay attention to risk alone though, and in spite of how important a goal this is, it always needs to be balanced with what we’re after in the first place, to make money from our money. While putting our money in the bank is ultimately a losing proposition, unless we find better ones, or rather, if there are not better opportunities at the time, this can indeed serve as the lesser of evils at times.

If we have our money in the stock market while it is tanking, or in bonds when interest rates are rising, we can lose much more than inflation, and in these situations, looking to hedge things completely may be the best way to proceed.

How Our Preferences Affect Our Investing Style

We often think of these strategies as being static, where somehow, we believe that our own personal preferences take precedence over what may actually be happening at the time. The significance of such a mistake will escape the great majority of investors, who have been taught that this is the only real way to do this, to take our personal goals and then hope that things play out to suit them.

Things don’t always work out that way, although they can in the midst of a long bull run, where we can fool ourselves into thinking that we are much better investors than we actually are. This is especially true if we pick our own investments, and when the sea is rising, it’s not hard at all to pick some boats that will rise pretty nicely as well.

We’ve seen this at various times, where so called experts were everywhere, and people would even quit their jobs and trade full time, being buoyed by the impressive results they achieved over this bullish period. When things turn around though, the men are separated from the boys so to speak and these people come to realize that they aren’t anywhere near as good as they thought.

We tend to enter investments with a long-term view, the view that what we will invest in will go up over a long period of time, and this is the gist of our strategy, to capture that.

We then hope that things will proceed according to our plan, but the funny thing about financial markets is that they don’t give a hoot about what our plan may be, as they will follow their own direction, or rather, the sum total of investor sentiment at any given point in time.

In a real sense, when our views, or rather hopes in this case, and the reality of the market collide, without a plan to manage this, we are left helpless against a stampede in the other direction and will simply get run over when this happens.

We tend to think that there is nothing we can do about such things other than to batten down the hatches and look to ride out the storm, and at least thus far, these storms have all passed, even though it can take years or even decades for them to end and the sun to shine again.

The reason we do this is because this is part of our plan, and at the very least, we need to be open to the idea that this may not be the best plan here, or even a good one. It might be a terrible one in fact, but the only way to know this is to be brave enough to question our own plan to discover how it measures up.

What Our Investment Goals Should Actually Be

We could describe the traditional approach to investing as being top down, where we look at long-term results and then conduct our investing to seek these long-term gains. That doesn’t sound too terrible on the face of things and this idea has certainly lured us into playing this game, given that the vast majority of us follow such a plan.

In order to seek out potential improvements to this, we need to explore what a bottom-up strategy would look like here. When we are looking at timelines with investments, we could look at the very long term, and we may want to do that regardless, but we also need to examine outlooks of a shorter duration to get an idea of what paths our investments may take along the way.

Let’s say we have some money to invest and we are looking to put it into a stock index fund. Since our goal is long-term capital growth, we only care what the outlook is for the market in the very long-term, so we think that the short and medium-term and even the fairly long-term outlook somehow don’t matter.

We even may have convinced ourselves, like most people have, that only the long-term outlook is knowable and outlooks of a shorter duration are not predictable and may even be random. So, we invest our money in the fund, not even caring that things are heading against us at the time. At some point later, we may be sitting with a losing position but still probably don’t care, because that’s not our focus.

Our overall goal though is making a profit over time, and it doesn’t really make sense to ignore the fact that, at the time of the investment, the outlook was poor and this should not have been a time that we should have ever considered going long the market.

If anything, we should have shorted the market with this money, although being short doesn’t mean that we will stay short, only when it makes sense to be, only when this is the direction that we are moving in.

Somehow, we have managed to believe that ignoring the market manages risk somehow, and when we actually do seek to manage it, for example by our being reluctant to enter positions that have a poor outlook within a manageable timeframe, we are adding risk to the investment, and perhaps even a lot of risk.

This is simply a perversion though, but a pretty popular one indeed. We are speculating on these things with the view toward making a profit, and to do this properly, this is going to involve our paying attention to both the potential for risk and for return, and look to strike the right balance between them.

Strategies that promote both goals should be preferred, and especially ones that serve both at the same time, our avoiding going long in this situation for instance. Entering a position with a poor outlook both reduces our potential return and increases our potential risk, and we manage both by avoiding these situations.

The same holds true when we choose to stay in positions that have a poor nearer-term outlook. We are taking on more risk here and also reducing our potential returns. When it is more likely that we will lose money than gain it over a certain timeframe, as long as that timeframe is manageable, if we don’t manage things then this is going to end up hurting us overall.

The goal with investing does need to be focused on making money, driving returns, and managing risk, but the truth is, few investors faithfully pursue these goals, or anything resembling them. What we do instead is just to take a certain view of our investments and then stubbornly hold on to these views in spite of what may happen to them over time.

This is a terrible approach though and if we ever want to help ourselves in the way that we ultimately seek to do, we’re going to need to cast off the old saws that have influenced us so much, such as markets are unpredictable in any timeframe shorter than the very long run, or that actively participating in our investments will be our undoing should be foolish enough to try this.

There is simply too much at stake with our investments to simply agree to be another brick in the financial wall, where we just do what we’re told and not ask too many questions. Without wondering enough about such things, we will never be able to actually pursue our financial goals properly.

Our goals do need to be at the forefront of our investing, but we first need to be clear on what they are, or at least should be, which is to make money and do so in an appropriately safe way. We need to let that be our guiding principle, and not just go with ideas that involve completely ignoring how we are progressing or may progress toward these goals.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.