Investing is necessary but we should never invest money we might need in the short-term
A bank employee phoned to ask us some questions.
She invested 10,000 € in three different investment funds a month ago and now is losing 5%. She wants to know which stocks she should invest in to get all her money back. Then we asked her why was she planning to sell the funds and the answer was she might need them in about 6 months.
When talking to the bank employee, she admits having invested in bank stocks after the bank offered her a loan to buy the stocks at a low interest rate. There has been no stock recovery in three years. She complains about not having enough money to average the purchase price while the stocks dropped half its value.
We asked her to consider building an efficient portfolio (diversified portfolio) but she denied because we work with an ideal horizon of 3 years (or more). Moreover, she explains she has saved 40,000 € on a long-term deposit. Our question then was why not investing part of the money, but her answer was she didn’t want to pay a penalty for withdrawing money before the maturity date.
At that point, we tried to show her a more global view of her financial needs.
We estimated her position in the tolerance profile scale. It had to be rather low or very low, around 1 or 2. Obviously, she is aware of her position but isn’t consistent with it. Instead, her investment funds correspond to a much more aggressive profile, probably 8 in the scale.
So we tried to help her understand that she is investing her assets incoherently. The money she probably will not need in the long-term is being invested in an asset with a 1% deposit and limited returns. She argues there is a possible penalty (0.5%). However, this argument doesn’t justify not changing strategies because no opportunity cost analysis has been previously done. On the other hand, the money she needed in the short-term was being invested in volatile assets, unsuitable for her temporal horizon.
After a quick overview of the current situation we were able to identify certain errors (which are common to small savers/investors):
-To invest without planning.
-To invest without knowing your risk tolerance.
-Lack of patience to stick to your previous decision.
-Confuse investing with speculating.
-To not carefully evaluate the real and opportunity costs of your investments.
Investors / savers often don’t make the most reasonable decisions. The bank employee case illustrates how financial psychology acts.
Finally, the bank employee understood she was taking unnecessary risks. She wasn’t prepared to invest. After paying close attention to her words we realized she had 0 risk tolerance. Her savings were to cover her short-term needs. It is not advisable to invest the money you might need to have handy.
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