There are two things needed to make money investing -> 1) finding an investment that will grow in value over time 2) finding the right investment opportunity that suits you.
So you want to find a good investment. Don’t we all!
The news media tend to focus on high-flying stocks - so naturally most people think of picking a stock that could go up a lot in price - when they think about how to pick an investment.
The stock market has shown to deliver consistent returns over the long term but will also go through periods when stock prices are falling. That means there are certain factors to consider before choosing which stocks to buy, and indeed whether stocks are even the best investment opportunity available to you.
First, consider the reason you are investing
Before you start your hunt for an investment, there are some important questions you need to ask yourself
- What are my objectives?
- What is my investing profile?
- What is my appetite for taking risks?
My Investment objectives
Your objective when deciding to invest can vary in detail but it normally falls under one of the following reasons.
Building a nest egg for retirement
To grow your money so that you have more money to retire with, you need to lean more towards higher risk investments with the best potential for growth. The lower the risk you take, the less possibility there is for your money to grow.
Investing in stocks has shown to be the best source of long term compound annual returns. The stock market also tends to reward risk-taking with the best long-term returns associated with small cap stocks.
Long-dated government bonds, for example 10-year US Treasuries, have provided investment returns consistently above inflation. The returns fall far short of equities but that is because the investment capital is not at risk unless you need to sell the bond before maturity. Holding bonds will reduce your long term returns but offer diversification and a layer of protection from stock market risk.
Short-dated government bonds historically offer a store of value. They keep up with inflation so offer a safe and liquid alternative to cash for investors nearing retirement.
A source of income
Certain types of investments make regular payouts to investors, while others don’t. To receive income, you must narrow your investing universe down to only the assets that payout. Dividend stocks and corporate bonds offer a source of income, while growth stocks and commodities do not.
A corporation or government will offer investors a fixed rate of return in exchange for the investment. The rate of return should compensate you for the level risk of you losing your investment. For example, if a company goes bankrupt debtholders (bondholders) get paid before shareholders. For those looking for safer investments but with a generally higher rate of return than government bonds, investment-grade bonds are a good choice. For those interested in taking higher risk to achieve higher income, junk bonds are a consideration.
Taking a chance
The rule of thumb is that the less certain an investment outcome, the higher the reward for taking that investment. It would be imprudent to invest all your hard-earned money into unlikely outcomes, but investing some small percentage of your portfolio in high growth opportunities can make sense. They will not greatly impact your overall return if they fail, but can make a big difference to your wealth if they succeed.
Small and midcap stocks as well as leveraged trading in commodity futures, forex or CFDs as well as cryptocurrencies are some of the most popular avenues for investors attempting well-above-average returns. Some altcoins (alternatives to Bitcoin) have earned 1000s of percent in the past few years, while many more have become worthless.
My investment profile
The most important building block in your profile as an investor is age. The older you get, the closer you are to retirement (when you will want to make use of your wealth). To make sure they have that wealth available, older people will tend to focus on ‘capital preservation’ by reducing risk. Younger people, who have more time to hold on during the times that an investment loses value, will focus on ‘capital appreciation’ by taking risks.
There are other things to consider too. If you’re reading this article, you are presumably quite new to investing or at least still learning. Beginner investors should tread carefully in the beginning and gradually get more adventurous (take more risks) with the investments they make as their understanding and confidence grows. A good choice for new investors is investing with the help of a professional money manager by investing in mutual funds or ETFs.
My risk appetite
Risk appetite is related to age but is also affected by existing wealth and personality. Between people of the same age, those with a higher net worth can afford to take more risk. On the other hand, some people are just born risk takers and others aren’t. It’s important to be honest with yourself about which one of these categories you fall under.
Let’s look at the different investment choices from a risk perspective.
Cash means your money is exposed to no investment risk so it is the safest - ‘Cash is King’ is a saying for a reason. The biggest risk to holding too much cash is inflation. Inflation means that each of those dollars, Swiss francs etc lose purchasing power each year. Beating inflation is one of the best reasons to invest rather than leaving all your money in the bank or under the mattress.
Alternative investments, including investments in hedge funds are the most risky but provide the highest source of potential return. Of course, cryptocurrencies can be added to this chart and should be placed on the far right as very high risk. Crypto is considered by some to be part of the alternative asset category.
A diversified portfolio would ideally have small elements of all these different types of investments to minimise exposure when one type goes through a downturn in prices. The difference between a risk-taking investor and a risk-averse investor is how each of these investments is weighted within a portfolio.
Takeaways
Diversification offers an investor the best chance at achieving long term returns.
Picking investments should be a function of trying to find the right mix for a diversified portfolio that best achieves your investment objectives given your investment profile and risk tolerance.
