This article has been written by Rishabh Sen Gupta, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
An Investment can be simply said to be the deployment of funds with the objective of achieving additional income or growth in value. Today investors are presented with a diverse range of investments in the form of investment avenues or financial products. In gist, financial products are the wide assortment of schemes designed by banks and other financial institutions to attract potential investors.
Financial Products can be further classified into different categories on basis of the duration of the investment, amount of risk involved and level of liquidity. The objective of this article is to provide insight pertaining to the personal factors that influence an investor’s behaviour before making a financial investment and also identify external factors that should be taken into account before making such a decision and lastly proceeds to provide suggestions while doing the same.
Personal factors affecting an investor’s behaviour
The personality of an investor is the sum total of their behaviour patterns, talents, interests and orientations. These traits are important to consider as they help to identify the tendencies displayed by similarly placed groups when it comes to investment decisions. Some individuals opt for risky investments while other individuals opt for risk-averse ones. Certain factors that help to gauge the sort of investment an individual is likely to opt for have been discussed below.
Age is one of the most widely used criteria for identifying financial risk categories. While young investors are often considered to be more likely to delve into high-risk financial investments the opposite is true when it comes to older investors.
Income level of a person
It has also been observed that people having a high level of income can readily bear risky investments when compared to individuals belonging to lower incomes. This is simply because they have more resources at their disposal which makes them more tolerant to risks.
Level of financial awareness
Studies show that an individual with a high degree of financial awareness makes decisions through thorough analysis and may delve into avenues that are not frequently tapped into and are considered unconventional. This is opposite for investors with less financial awareness who opt for more conservative ways of increasing funds readily available to them which are comparatively risk-free.
Gender and Marital Status
It has been shown through research that women are better at perceiving risks in terms of the effect of gender when it comes to investment decisions. However, once one’s level of knowledge and financial markets increased, this weakened the effect of gender on prognosticating the level risk attributed to such. Additionally, results pertaining to whether a person’s marital status has an effect on risk perception have shown different results while some data collected shows that bachelors have more financial risk tolerance than married couples other studies show the converse to be true.
An investor’s socio-cultural environment, family and close environment which impacts their investments are deemed as socio-cultural factors. An individual’s attitudes and thoughts are largely influenced by their culture. In other words, the socio-cultural situation of an individual also has an effect on the decisions they make.
When the question of making decisions arises, reference groups must be factored in as they play an important role in shaping the behaviour of individual investors. Research has gone on to suggest that 80% of the purchasing decisions of an individual were influenced by someone else’s direct recommendation. This points towards the fact that individual investors are affected by the group they are in while making investments. An example of this can be perfectly alluded by the fact that the recommendations of those who have invested in the securities exchange for years have been taken seriously as a point of reference.
External Factors that should be taken into consideration before making an investment
Factors that play a role when it comes to investments are cash flow, liquidity, investment duration, return ratios. While making investments a keen investor will often look at inflation along with interest rates while making forecasts so as to protect their savings and reap the maximum benefits possible. Thus, individual investors in order to increase the value of their investments should always direct their investments to areas of high value of income that exceeds the inflation rate.
Role of Cash Flows
The cash flows of a company are usually provided in their cash flow statements. A cash flow statement provides vital information about the company and helps to understand how much money a company is making and spending. Thus, it shows the liquidity and solvency of the firm which is vital for its survival. Not only does it provide information about the financial position of the entity, it also helps to provide insight regarding a company’s cash-generating abilities through its core activities. These help investors while making decisions pertaining to investment as it serves a valuable measure of profitability and long term outlook of the company.
Investments can be of two kinds depending on the length of time they last. Short term investments are those which are intended to be held in an investment portfolio for less than one fiscal year. Conversely, long term investments are those which are held by an investor for longer than a year. Both these types of investments carry different expectations.
Long term investments are done with the intent of building resources keeping long term goals in mind such as retirement. Short term investments may be made on the other hand keeping short term goals in mind such as purchasing a vehicle or paying of an educational loan. Also, an investor who opts for a long term investment looks for higher returns on that investment whereas, a short term investment is generally associated with smaller returns. Additionally, the risks associated with both are quite different. Long term investments carry more risks associated with volatility in the market whereas, short term investments are prone to inflation which can render them insufficient. It is generally advisable to strike a balance between the two and have a portfolio consisting of risky and less risky investments. It is advised that younger investors choose riskier and long term plans and older investor should opt for short term less risky ones.
Liquidity is defined as the ease with which an investment can be bought or sold without significantly impacting the price of that security. Investments that can easily be brought or sold are said to be liquid whereas the inverse is true for illiquid investments.
Mutual funds, exchange-traded funds (ETF’s), stocks and bonds are generally deemed to be relatively liquid whereas, private debt and private equity are deemed to be relatively illiquid as they lack standardized terms making it hard for investors to evaluate, and in turn, buy and sell them. It is advisable to have a combination of liquid and less liquid investments. Although less liquid investments are hard to buy and sell, they yield a high premium which incentivizes investing in them. Therefore, in order to secure such investments it is likewise important to invest in highly liquid low premium yielding funds so in times of adversity, the necessity never arises of having to sell the high yielding ones.
The return on investment is determined by calculating the net profit from a company or other investment by the total amount of money spent. Return on investment is typically expressed as a percentage or ratio that compares benefit to capital. It’s a widely reported figure that’s used in a variety of financial analyses.
Generally speaking, investments with a higher return on investment ratio bear greater risk, and there is a chance that certain investments will lose money in some years. This must be factored into the overall financial framework, and more risky assets can preferably be part of your long-term investing strategy. To balance your total return on investment, it is recommended to get a wide array of investments, with some investments bearing less risk and producing lower, but more stable investment returns.
Very often individuals often invest without knowing which investments would be the best suited for them. Therefore, before arriving at any decision it is always advisable to create a personal road map and make informed decisions. Investors should always evaluate the level of risk they are willing to take by considering certain factors such as age, level of income and marital status that have already been discussed above. While it is encouraged that the advice of those most trusted is taken, a wide array of opinions should be considered before arriving at any decision.
Also, one should be clear about their strategy by assessing the cash flows of an entity, the level of liquidity, duration of investment and its rate of return. Lastly, as already discussed above, it is best to invest in a mixture of securities yielding high premium as well as low premium. This optimizes one’s portfolio as it promises short term gains as well as long term benefits.
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