3 Key Basic Concepts Of Investing We Often Forget
As long as you are an able adult who is making a living, you will directly or indirectly be investing your money in one way or another.
And if you are one of those individuals who consider saving as a form of investing, then we could stretch investing activities all the way back to the youthful exuberance of kids. These days kids start saving at a very early age.
But on a more serious note, if you are earning an income, then surely you will eventually start having thoughts about future. You know… the future where you don’t have to work so hard, if at all, to maintain your living standards… or even just to put food on the table.
It is often during these self-reflective times where you start having more serious thoughts about investments so that your money will grow along with you.
In some way, inflation is a motivation to invest. But more than that, investors have a view of attaining financial freedom one day. That could be the moment where you enter retirement, or the day when you decide that you have enough money in the bank to stop working altogether.
Young adults new to the idea of investing often make the mistake of thinking that all they have to do is put their money somewhere and watch it grow. More disturbingly, many even invest just so they can boast about it to their friends in Facebook group.
But if you have been around the block, it means much more than that.
Every investment must be centered around 3 BIG concepts. These concepts are so basic and intuitive that you’d wonder how you failed to follow them with discipline when you lose money. Somehow we are prone to miss them when making decisions.
You KNEW them. Yet more often than not, you forgot about them at the most critical moment.
1) It must generate a return
Most people will be elated to see a fixed deposit interest rate of 1%. It is way above the standard interest rates of about 0.1% for standard savings accounts.
Then they get thrilled to see an investment that has a history of 5% year-on-year returns.
But really. What are you left with when inflation is factored in?
On top of that, historical data should never be used to calculate how much return you can potentially get.
History can be interesting to read about. But when it comes to investments, what happened in the past can never be a certainty of what will happen in the foreseeable future.
Just look at pyramid schemes for example. In early stages, real investors might really get a return of 10% for a few years. This historical performance data is then fed to new investors to grow the fund. Eventually, cracks become gaps. And gaps become holes. Then everything collapse.
Who could have seen the real estate bubble that burst in 2008? Other than savvy financiers who understood the numbers, average investors had their portfolios burnt to the ground. Before the implosion, historical data actually painted a beautiful picture of the outlook for real estate.
All these means that if you want to generate a return on your funds, all those vehicles that will undoubtedly be clobbered by inflation will have to take a back seat. This refers to things like bonds, deposit certificates, savings, etc.
2) Measure your risks
One of the rules in investing that is carved in stone is that “higher returns equals higher risks”. There is no way around it.
Because let’s say for example that you are key promoter of an investment vehicle. Whether this is a fund, a business, or real estate doesn’t matter. If you are 100% certain that you will be profitable, why would you want to offer a high return just to entice investors? A long queue of investors would automatically form at your door begging you to take their money.
But if you are only 50% certain of success, then you might have to raise the returns to attract investors so that they get a bigger bang on their capital.
Want another example? Alright.
Let’s talk about penny stocks. The reason why penny stocks can look so attractive to an investor is not just that they are cheap. A bigger reason is that any uptick in share price means a higher gain in value. If a share is a penny each, an increase in an extra penny would mean an instant 100% capital gain!
But on the other end of the stick lies the risk factor in such stocks. The primary reason they are lowly priced is because they are so unstable and unpredictable that the market has shunned them. This depresses the price and the only way they will sell is to sell low.
You would be taking on a big risk if you pump your funds into these shares. They can fail the day after tomorrow…
So from an investor standpoint, the higher return on investment you want, the more risk you have to take on.
This leads us to the next problem.
How much risks can you accommodate without going insane?
You might have a laugh when you hear the story about a friend who endure sleepless nights on days with major stock market movements. But you will be in the same mental state should your money be on the line.
Volatility can be celebrated when you are winning. But it can bring misery when you are on the wrong end of a bashing.
You are the only person who is able to judge exactly how much risk you can tolerate. And if you are admittedly a risk-adverse person, you will be doing your health a favor by going for less risky investments albeit a lower yield. Treat that opportunity cost as medical bills for your health.
Even the wildest of risk takers understand that concept of diversification. This is even when they have an ultimate certainty of an investment’s success.
Some commentators might argue that great investors are often contradictors. Because if they are so sure of a stock’s performance, why don’t they go all in? Is it because they are not so sure with their investments after all?
But that is the wrong way to approach this topic. It would be like asking why a soccer team fields 11 men on the pitch when only 1 goalkeeper is allowed to protect the goal with his hands.
Nothing can ever be certain in investment. And diversification is always part of the overall strategy of any investor. Other than for hedging risks, there could be many other reasons why people hold onto a number of different items in their portfolio.
Because if something really goes wrong with your BIG bet, you are basically screwed if you have nothing left in the tank.
If you are a huge risk taker, you should still limit your risky bets at 50% of your total funds. The other 50% should go into moderate and stable investments so that you don’t go home one day to a foreclosure notice hanging on your front door.