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Tuesday, August 21, 2012

What Type of Investor You Are?

Managing your own expectations is a big part of your investment planning process, and it starts with figuring out exactly what kind of investor you are. Once you know that, the rest of your investment planning will fall into place much more easily. Though there are many subtle variations in investor profiles, the two main types are buy-and-hold and market timing. Where you are along the time horizon, your risk tolerance, and your personal style all factor into the type of investor you will be.

Here are some good questions to ask yourself to determine your investor profile:

• Do market fluctuations keep me awake at night?
• Am I unfamiliar with investing?
• Do I consider myself more a saver than an investor?
• Am I fearful of losing 25 percent of my assets in a few days or weeks?
• Am I comfortable with the ups and downs of the securities markets?
• Am I knowledgeable about investing and the securities markets?
• Am I investing for a long-term goal?
• Can I withstand considerable short-term losses?

Market timing in funds used to be viewed as a nuisance, an arcane practice by a handful of cunning investors. But timing is now under the microscope of regulators, who say the practice is unfair to individual investors — and illegal, in some cases.

If you answered yes to the first four questions, you are most likely a conservative investor. If you answered yes to the last four questions, you are more likely an aggressive investor. If you fall somewhere in between, you could call yourself a moderate investor. Conservative investors typically follow the buy-and hold strategy, where aggressive investors are often market timers. As you might expect, moderate investors tend to mix the two types into one blended profile.

Buy-and-Hold Investing

When it comes to buy-and-hold investing, you may have heard that it doesn't really matter what the market is doing when you get in, as long as you stay in. There's a great deal of truth in that line of thinking. Studies show that stocks can grow on average up to 10 to 12 percent annually, and long-term treasury instruments can grow at a rate of up to 6 to 8 percent per year. Combined with the miracle of compounding, a long-term outlook coupled with a solid, disciplined investment strategy can yield big bucks over twenty, thirty, and especially forty-plus years.

The trick is in staying in the markets and not missing its sharp upturns. People who engage in market timing — market timers, those Dalal Street daredevils who try to get in and out of the stock market at the most optimal moments — risk missing those market spikes. And that money is hard to make back.

The Downside of Market Timing

Market timers also generally experience higher transaction costs compared to those of a buy-and-hold strategy. Every time an investor sells or buys securities, a transaction fee is incurred. Even if the market timer achieves above-average returns, the transaction costs could negate the superior performance. Plus, trying to time the market can create additional risk.

Consider the time period from 1962 to 1991 of US stock market. An investor who bought common stocks in 1962 would have realized a return of 10.3 percent with a buy-and-hold strategy. If that same investor tried to time the market and missed just twelve of the best-performing months (out of a total of 348 months), the return would have been only 5.4 percent. It must be admitted that there's a flip side to this theory. If the investor had jumped out of the market during its worst periods (like the 1987 crash and several subsequent bear markets), returns would have been even higher than if he'd stayed invested during the downturns.

One additional negative aspect of using market-timing techniques is tax reporting complications. Going in and out of the market several times in one tax year (sometimes several times in a month) generates numerous taxable gain and loss transactions, all of which must be accounted for on your income tax return.