Many articles and books have been written about what makes a good investor. A lot of these articles look at some of the most famous investors, like Warren Buffet and George Soros, and analyze what makes them successful. This is a sort of ‘bottom-up’ view of how to become a success at investing.
Let’s be honest though. As much as we can hope and dream, there’s little chance you or I will be the next Buffet or Soros. The best we can hope for is to beat the market consistently by a bit over time, while managing risk and reaching our own personal investment goals. Here’s what I believe are the top three general traits that make a solid, personal investor.
Understands Risk and His or Her Personal Risk Tolerance
A major part of investing is managing risk. In general, more risk equals more return, but more risk also means more variance. Sure, stocks will outperform bonds and certainly cash in the long-term, but the long-term may very well be twenty to thrity plus years. In 2008, you could have lost about half of your money if you had all of your money into stocks.
Understanding how much risk you are taking when you invest and understanding your own personal risk tolerance are very important. First, you need to understand how much risk you are taking. If you are buying stocks on margin or buying leveraged ETFs, you need to understand that you are significantly leverarged and taking on considerable risk. This may or may not be for you, depending on your risk profile.
In general, the younger you are, the more risk tolerant you should be. If you are thirty years old, have $50k of savings, and have all of your money consistently in cash over the years, then you are killing your returns over time. Sure, 2008 was a ‘great’ year for you, but you will miss out on the bull markets as well. Here is what that $50k will be when you are 40, 50, 60, or 70, when you compare a cash return of 4 versus a stock market return of 8%:
Time Cash Stocks
40 (10 years): $74,012 $107,946
50 (20 years): $109,556 $233,047
60 (30 years): $162,170 $503,132
70 (40 years): $240,051 $1,086,226
Think about that a little if you consistently keep most of your money in cash. Compound interest may very well be the best invention of all time.
Understands Diversification
Diversification is often touted as the only “free lunch” in the stock game. This is because you can mitigate sector risks by investing in a variety of companies. You don’t have to worry that a tech collapse will kill your whole portfolio because your portfolio is diversified among tech, health care, finance, consumer staples, etc.
Proper diversification is important for most individual investors. But there is such a thing as becoming too diversified. There is no need to invest in 20 different mutual funds for example. A mutual fund in of itself diversifies your portfolio, since the mutual fund invests in a hundred plus stocks (provided the mutual fund invests across sectors). So you are needlessly racking up fees among mutual funds by investing in tons of them.
While you decrease your risk with diversification, you may decrease your returns as well. This is only the case though if you feel very strongly about a certain stock or sector. If you really believe a certain company or sector will outperform the market, your overall return will obviously be much higher if you invest 50% in that company or sector versus 10%. Again, this all goes back to risk tolerance. Buffet is famous for making big bets on certain companies and sectors, but his risk tolerance was much higher than most individual investors.
Understands How The Game Works
In the long-term, the best value investments show the most promising returns. Essentially, Buffet-style deep-value investing does very well over the course of years and perhaps decades. However, in the short-term, the market is highly emotional and psychological. The price of a share of stock is just as influenced by how popular the stock is among traders, margin calls, and the like.
You don’t want to be too overleveraged and find yourself whiped out because the market becomes irrational for a week. Again, this all goes back to managing risk. You have to remember that the price of a given stock on any given day can be influenced by just about anything, so you don’t want to hurt yourself due to the short-term irrationality of others.