Investing is not a game, it is not science either. This is why statistics plays such an important role in investing (a topic that we will leave for a different post), and why no one should believe statements from financial advisers such as: “I assure you 10% annual return,” “This investment offers 5% annual return and is risk free,” and so on.
What I am trying to get across is that everyone that has an income should be investing, but that it is important to acquire a basic knowledge of the financial markets before doing so, even if you are going to go with a financial adviser, a private banker or any type of asset manager. Why? Because the most important person for each of us is ourselves, and if a money manager has to pick between the well being of himself and the one of the client, it will definitely pick himself. It gets worse if you are a medium or small investor, since your financial adviser will always fulfill the big client’s necessities before yours. So, to sum up we all need to have a basic understanding of the financial markets before starting to invest, this is the only way to shield our patrimony.
In this post I am going to provide the 10 most important points that you should have clear before you start investing.
1. Should you be investing?
I know that before I said “anyone with a salary should be investing,” but there are particular cases in which this might not be true, at least for some time. If you have debt at a high interest rate (almost all credit card debt will match this definition) you should pay it off entirely before even thinking about putting any money into the market. It is simple to understand why. If you owe money and the interests are, fore example, 10%, it doesn’t matter if you can invest in the markets and make an average return of 9%. You are still losing 1% in comparison with the situation in which you pay off all this debt. Now, if you have a mortgage with an interest payment of 3%, you should not pay off the whole mortgage before you start to invest. In this case you can make, using our previous example, 9% investing and only pay 3% interest for the mortgage. So you will make 6% more than if you just completely pay off the mortgage. The relationship is oversimplified in this explanation, for example that 9% return is not secured; it might vary depending on the market conditions, while the debt will still be due regardless. This is why a lot of radical risk-averse people would prefer to pay off the debt before investing, despite of proven fact that, in average, they are losing money. The second situation in which you should not invest, even if you have a salary, is that one in which you don’t have an emergency fund. Every rational person should keep some amount of money in an account just to make sure that an adverse event does not challenge her financial situation and that she doesn’t need to pull money from her investments. However, if you are debt free, you have an emergency fund, and you have a salary… You better be investing!
2. What are you investing for?
Are you investing to pay for your kid’s university, to buy a new car, to take that around the world vacation that you have always dreamt of, to enjoy a nice retirement, to have a passive income? As you can see, there are a limitless number of reasons to invest. You need to understand yours because depending on what you want to invest for; you are going to use different investment vehicles to achieve your goals. Let’s give a few examples to better understand it.
If you have a sizable amount of money and you want to leave of it, or just have it produce some income for you, you can buy dividend stocks and bonds that will assure you a stream of cash. If you get the right mix, you can enjoy a steady income over the years in order to use as you please.
If you meet the following criteria
You are in your 20s or in your 30s
You have an emergency fund
You have a salary
You are debt free
You don’t have the need to pull money out in the next decades
you should create a balanced portfolio with a high level of risk. Most likely it would include a high percentage of equities and a sizable exposure to emerging markets with a high growth potential.
3. There is no return without risk
No one, wait I’ll repeat: NO ONE is telling the truth if they say they can offer a return higher than the risk free with no risk. It is just not possible. In our post Risk in finance and the why of risk management we gave a comprehensive explanation of what risk is and how to measure it, so take a look to refresh your mind.
4. You have an optimal risk target, find it!
In the investment world, you should not aim for a particular return; it is never the right strategy. The process should start by identifying your level of risk, and only then maximize the level of return for that particular level of risk. The real key variable is risk because at the end of the day, if you risk too much you might go bankrupt and you don’t want that! This is why we need to decide what level of risk is appropriate for us. How do we do it? We need to assess our risk profile. In most developed countries, registered financial advisers are required to assess the risk profile of their clients. These financial advisers will provide a questionnaire that will try to gauge the following characteristics of the investor:
Time horizon
Cash requirements
Attitude towards risk
Financial situation
At the end of the day what the financial advisers are trying to find out is what amount of money are you willing and able to lose within a particular level of probability. You should try to find this number before committing any money to the financial markets. It will be truly dangerous to invest in a vehicle in which you can lose more money than the amount you are comfortable with losing. As you can see, you not only have to understand your level of risk but also the different investment vehicles in order to know what is the risk of investing in them.
5. Diversification is key
In order to diversify you need to know about the different asset classes. We are currently building a database with as many possible investment vehicles that exist with their description and characteristics. For now, this are some of the most common investment vehicles, including alternative assets: stocks, bonds, derivatives, real estate, commodities, derivatives, hedge funds, venture capital, private equity…
6. Economies follow boom/burst cycles
Economies, as human emotions, rise and fall. Understanding how the economic cycle works, in which phase do we stand, and which type of companies and investment vehicles perform better in each particular phase of the cycle is completely crucial to perform in the investment world.
7. Always question your investment selection
Understand that if you are selling, someone is buying and that if you are buying, someone is selling. So, there is someone in the other side of the trade that is, on average, as smart as you. Try to find out why that person is taking the other side of the trade. In other words, take your strategy and try to see how it could go wrong and with what probability. This reflection might show you that your strategy is not as robust as you thought or it might give you even more reasons to invest, regardless; it is a necessary and sometimes forgotten step.
8. What is the cost of investing?
Now that we know our risk level and that we should diversify we need to focus in which investment vehicles we are going to use to create our portfolio. We cannot stress sufficiently how important the cost of an investment is for its final return, and how many times these costs are completely neglected by the investor. The costs come from different sources: brokers, financial advisers, investment vehicle, and others. You can understand how to minimize these costs and control them, and only then, it will make sense to invest.
You should always do the appropriate due diligence, find out how the fees of the different brokers, financial advisers and investment vehicles relate. This is substantial to realize the highest potential returns. The final, but not least important, type of cost that we should care about is the cost associated with taxes. Understanding the tax treatment of the different type of investment vehicles and their returns is key for investors.
9. There will be ups and downs
The markets are not gentle, be prepared. You might see green from the moment you start your portfolio, but most likely it will be a bumpy ride. The best strategy is not to continuously check how your investments are doing. This might make you sell at lows and buy at highs. You invested due to some reasons, and while the reasons that make you invest in something do not change you should not care about the short and medium term price action. History teaches us that in the long run a buy and hold strategy in a diversified portfolio should enjoy significant returns. Just to put an example, there is no 20-year period in the history of the NSE in which, after adjusting for inflation and accounting for dividend reinvestment, you would have had a negative return. I understand that the fact that this hasn’t occurred yet doesn’t mean it will never occur, but is just some nice food for thought. So, once you invest, stay patient and calm, try to keep emotions out as much as possible and only rebalance your portfolio once some change in the markets makes your portfolio inefficient.
10. Stay current with what’s happening in the world
There will be economical, political, environmental, social… and many other types of events that are going to be affecting your investments. It is really important that you understand what is happening in the different fields that affect your investments in order to understand what can happen to them. An early identification of a future trend can save you or make you a lot of money. Imagine that you have a lot of your money tied up to oil related investments. If suddenly a new energy is discovered that can displace oil due to its better characteristics, cost, quality, power, availability, environmental impact, accessibility… you might want to start limiting your exposure to oil, and the only way to find out about this type of news is by reading what’s happening in the world. I recommend to always read the news from different countries and also associated to different types of political affiliations because how some news are presented will be affected by the background of the news provider.
Keep on optimizing your strategies.
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