Is investing in the Stock Market the right place for your money?
Suitability is the all-important Litmus Test.
In this fourth in a series of articles for Middle East Business by our esteemed Capital Markets Editor, Edward Grey, the importance of an investor’s suitability requirements is discussed.
by Edward Grey – Capital Markets Editor/ Middle East Business News & Magazine
Over the years, I have had people ask me about whether they should invest in the stock market. Invariably, they speak of a ‘friend’ who gave them a ‘great stock tip’, or some television stock market pundit talking up a stock. My answer to them is always a simple question.
“What do you think is a suitable investment for you?”
Silence. Pause. “I don’t know” is often the response.
“Suitability Requirements” is not only a prerequisite tool for any legitimate financial advisor or broker to assess what is right for you, it is a guide for you to clearly understand your ability to actually achieve your financial goals.
Before investing your hard earned money, step back and think carefully about a few very important things.
First, what are suitability requirements? Suitability requirements are a set of questions that help you understand what types of investments will help you achieve your goals. They help you look objectively at your assets, income, debt, and tolerance for risk. By understanding this, you will be able to develop a clear, realistic strategy to reach your financial goals.
For example, if you own property and have cash saved, but have no income, you may not want to invest in high-risk stocks since any loss incurred may lead you to deplete your assets. In fact, you most likely would want a portfolio of ‘asset preservation and income’, such as dividend paying blue chip stocks and low risk corporate bonds.
If you like the idea of high returns, like those investors that have realised gains in excess of 23% over the past three years investing in ‘value stocks’ in the U.S. markets, you have to ask yourself “Am I willing to lose the same, if not more, if the market has a down turn?” Stocks that may realise above average gains are also likely to incur above average losses during market corrections.
So, if your answer is “No, I am not willing to risk losing a lot” then your tolerance for risk is low, which means a portfolio of value stocks is not right for you.
Also, do not forget about inflation and taxes. A corporate bond that offers an 8% annual payment is not your “real rate of return.” If the inflation rate in your region is around 3%, as it is in Jordan, that 8% return has a real rate of return of only 5%. Also, depending on where you live in, investment returns may be subject to either income or capital gains taxes that, when coupled with inflation, may bring the real rate of return even lower.
However, let’s say that you are about 40 years old and own property, that you have stable income and a nominal amount of debt (the interest of which may be tax deductable), and have $250,000 cash. Further, you are willing to incur a relatively high loss in the pursuit of high gains (i.e., that you are risk tolerant).
In that instance, a portfolio that includes high-gain/high-risk stocks may be right for you. As a general rule of thumb, however, investment in these high-risk stocks should be limited to 10% to 15% of your overall wealth portfolio so that any loss will not significantly impair your entire wealth portfolio.
Ok, but what about that good friend with that ‘great stock tip’? Skip it. First, your friend is not you and most likely does not have the exact same suitability requirements that you have. So, what may be good for your friend may be bad for you. Second, you have no idea where your friend got this great tip, though its unlikely that it came from any specialised, comprehensive research tailored towards your goals.
And as for those television stock market pundits, be careful. If the pundit is touting a growth stock, it may be a good idea, so long as investing in a growth stock is suitable for you. However, expect to wait a while to realise gains. Ideas touted by television stock market pundits, if they have any merit, are already known to professional money managers and institutional investors. So, it is likely that any public information or new insight is already factored into the price of the stock. That said, you may still be able to realise gains in the long-run.
If the television stock market pundit is touting a quick value stock, turn off your TV because this ‘great insight’ that you just heard, millions of other people heard it too. Whatever ‘quick value’ was in the stock was already traded away the moment it was broadcast on TV. In other words, by the time you buy the stock, it will be too late.
The most important thing to remember about investing in the stock market is that the stock market is a ‘Zero-Sum Game.’ A Zero-Sum Game, in the Economic field of Game Theory, is a game where there is always one winner, and one loser. If you buy a stock expecting it to go up in value, on the other end is a seller expecting it to go nowhere, if not down. If it goes up, you‘re a winner. If it goes down, you lose.
Now, back to our last example of the television stock market pundit touting a ‘quick value’ stock. As noted, whatever gain may have been in that stock was already traded away and reflected in the value of the stock. If you choose to go out and buy that quick value stock anyway, you’ll be that loser of the Zero-Sum Game because the seller already realised the quick value gain, and simply wants to cash out.
In conclusion, your best chance at being a winner is to first understand your ‘suitability requirements.’ Sit down with a professional money manager or stock broker, talk through what is suitable for you, and develop a portfolio of stocks, bonds, and money-market instruments that may help you reach your goals. Considering the number of people who invest without understanding what is suitable for them, who invest based on a ‘tip’ from a friend, or who invest in whatever the television stock market pundit says, you’re likely to be winning more often than losing.
Edward Grey is a Managing Director at Watts Capital, LLC, a Manhattan, N.Y. based Wealth Management and Investment Banking firm. Mr. Grey advises both domestic and MENA region companies with a focus on biotechnology, genomics, and bioinformatics. Mr. Grey also serves as the Capital Markets Editor of the Middle East Business Magazine & News. Mr. Grey is a graduate of Carnegie Mellon University, where he received a Bachelors of Science for both Economics and Industrial Management, and Vermont Law School, where he received the Award of Academic Excellence for Law & Economics. Mr. Grey is also a Level II Candidate for the CFA designation.