One of the fundamental principles of financial planning is that one's age - or life stage - should have a significant influence on the composition of investment portfolios. This principle is predicated on the fact that for the average investor, the ability to take risk diminishes as retirement approaches. In fact, most major mutual fund groups offer life-cycle funds that automatically take care of the asset allocation decision automatically for investors, by shifting from higher-risk assets such as stocks to lower-risk fixed-income securities as retirement comes closer.

In practice, however, an investor may or may not always follow the life-stage approach to investing, as there are a number of additional factors that also have a major influence on shaping an investment portfolio. These include external factors such as the state of the economy and financial markets, and internal factors such as personal milestones and personal experiences. For the average investor, personal milestones and experiences are perhaps among the most important influences in shaping investment portfolios. As people get married later in life and work into their 60s (and later), personal milestones - rather than age - will continue to be one of the most significant influences in determining investment decisions and portfolios.

Personal Milestones and Portfolio Construction
While factors such as risk tolerance and saving habits vary from person to person, many people have similar major milestones in their lives: starting a career, living with a partner, buying a house, starting a family and so on.

An approaching personal milestone is perhaps one of the most powerful motivators for an investor to learn about a financial or investment product. A young adult who has just started working may not be inclined to spend time and effort on learning about housing options and mortgage products, but in a few years time, when that person has saved enough money for a down payment on an condominium and is looking for one, he or she will probably be spending hours pouring over real estate listings, viewing condos and learning about the pros and cons of fixed-rate versus adjustable-rate mortgages.

Similarly, purchasing life insurance coverage becomes a pressing issue when one has a spouse or starts a family. Likewise, as one's pool of savings grows, there may be a greater degree of interest in learning about individual stocks, advanced fixed-income securities and other products such as options and commodities.

The best practice in these cases may be to start the education process well ahead of time, when a personal milestone is some years ahead rather than just around the corner. Over the long term, this approach is bound to pay dividends, since there will be ample time to conduct the analysis and "due diligence" that should be undertaken before making a major investment decision.

An Example - the Tuttles Vs. the O'Hares
As an example, consider the case of two hypothetical couples, the Tuttles and the O'Hares. The Tuttles like to take their time before making a major purchase and analyze the outcomes of various scenarios before they put their money down on significant investments. The O'Hares, on the other hand, believe in striking while the iron is hot - in other words, their view is that time is of the essence when making an investment decision.

The Tuttles save money diligently over the years and in five years, have sufficient funds to make a significant down payment toward the purchase of their first home. During this period, they stay away from risky stocks, preferring the security of certificates of deposit and money market funds. They also defer their decision to purchase a home for a year because their view is that house prices will decline substantially and they are willing to wait for the home of their choice. In the meantime, they evaluate the various mortgage products available and have decided to opt for a fixed-rate mortgage, because interest rates are quite low and they like the fact that their monthly payments are fixed.

The O'Hares, meanwhile, have already purchased a home, but ended up spending more than they wanted because the housing market was booming at the time and they did not want to miss the opportunity. Their mortgage debt was also much higher than their comfort level, partly because of the high price of the house and also because their down payment, which had been invested in speculative stocks that have since plummeted, had shrunk considerably. They have also opted for an adjustable-rate mortgage because of the attractive interest rate, paying little attention to the fact that it is a teaser rate that will reset at significantly higher levels in a few months time.

Over a lengthy period, say, 10 or 20 years, it is quite likely that the Tuttles will be much further ahead in their quest to build wealth than the O'Hares, since their measured approach when making investment decisions could enable them to spot hidden risks and pitfalls that may not be apparent to the hasty buyer. The lesson is simple - when it comes to a major purchase or investment, do your homework, because a few hours spent in educating yourself might save you thousands of dollars over the long term.

Personal Experiences and Portfolio Construction
Personal experience is perhaps the most influential factor in shaping one's risk tolerance, and by extension, the composition of an individual's investment portfolio. Losing a large amount of money on a "hot tip" could lead an investor to shun speculative stocks and invest only in blue chips for years.

Personal experiences in the investment realm can be classified into positive experiences - for example, making money on a stock idea - and negative experiences, such as bankruptcy or foreclosure on a property.

Positive Experiences
Positive investment experiences are great while they last, but may have the undesirable side effect of leading to complacency and undue risk-taking. There are numerous real-life examples of investors over-extending themselves in the stock market or real estate because they had a few successful investments initially. The temptation to leverage oneself to the hilt where investments are concerned should be resisted, since leverage is a double-edged sword that amplifies returns on the upside but also magnifies losses on the downside. As well, concentrating one's investments in only one area - whether it is equities, real estate or commodities - flouts one of the cardinal rules of prudent investing: diversification.

Negative Experiences
Negative experiences, on the other hand, can inflict considerable damage to one's financial health in the short term, but may hold valuable lifelong lessons. As Oscar Wilde noted, "Experience is simply the name we give our mistakes." Neglecting to read the fine print in a mortgage contract, or buying a hot stock on the spur of the moment without researching it adequately, may end up in being a very expensive lesson for the hapless investor. But if it can prevent the investor from making a similar or bigger mistake in the long run, perhaps the expensive lesson may have been worth it.

Unique Experiences
Unique personal experiences can also influence investment choices. For example, an information technology professional may have a high proportion of technology stocks in his or her investment portfolio, based on the notion that their familiarity with the sector gives them an edge in terms of picking technology stocks. The obvious risk here is of lack of diversification. While your profession or area of expertise may give you an edge in spotting winners in your sector, ensure that your investment portfolio is adequately diversified.

As another example, an investor may choose to focus on companies that are developing treatments for a specific ailment because he or she, or a family member, suffers from it. This may be a worthwhile endeavor from the perspective of getting more information on potential breakthroughs or new treatments. However, the investment merits of such stocks should be weighed on an objective and rational basis, devoid of undue hype or hope. This is particularly true in the case of the volatile biotechnology sector, where trading ranges for stocks are quite wide.

The Bottom Line
Personal milestones and experiences are among the most important influences in shaping portfolios and risk tolerance. While they are powerful motivators to learn about financial products and commence making investments, investors need to guard against undesirable side effects, such as excessive risk-taking and lack of diversification. It also pays to do your homework prior to making a major investment or purchase, since ignorance or inadequate knowledge can cost an investor plenty of money over the long term. A little knowledge can be a dangerous thing, and this truism especially holds in the world of investments.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.