There are a few key questions I always ask before making any investment. By knowing what to ask and what to look for, the decisions will be so much easier to make.
Below I am sharing the 10 key questions I want answered before I make an investment. These are of course individual but I hope they can give you some inspiration too and remember that all investments have risks!
Before making any investments I would recommend that you first have your financial security (6-12m worth of income) taken care of and that you keep that money in a savings account.
The questions I want answers to:
1. Do I understand the investment?
This is a very important question because if I don’t understand the investment, how it works, how they make money etc., how can I ever assess the risk and the potential return? There might be situations where I won’t follow this rule to 100% but that will for sure be an exception and when that happens it will be for a very clear reason.
The first thing that pops into my mind is crypto-currency. I do understand the intention and how it works (roughly) but I don’t understand the algorithms behind it. That is a risk and I have very limited possibility to personally evaluate this and the same goes for how safe or unhackable it really is. Even if I don’t understand exactly how it I works, I might still consider investing in crypto as a small part of my portfolio with the purpose of a hedge BUT with full understanding that I might lose it all for reasons I might not even have thought of nor understood (I might do a separate post on crypto).
2. What are the Key Risks with the investment?
Once I understand the investment, I can assess the key potential risks with the specific investment. It might be fierce competition, worse business sentiment, products that are easy to replicate, regulatory changes etc. Though, there are always a few factors tending to stand out from the broader risk factors and those I really want to know so that I can make up my mind whether I am happy with them or not.
3. What is the worst case scenario?
If shit really hits the fan with this investment, how much do I stand to lose? This will vary for every investment but could be up to my full investment (even more if leverage is used). The worst case should of course be very unlikely to happen unless the entire world is going under, else I should not be getting into this investment in the first place. Still I always have to know the potential downside so that I can make my own call whether the investment is worth the risk or not.
4. What does the risk return profile look like?
What are my return expectations on this investment and how does it compare to the potential risk? Here I will have to use some assumptions and maybe look at historical performance, look at similar investments and their returns and how risky they have been (valuation fluctuations). This will also be very specific to each investment but by understanding the business and how the investment and its competitors have behaved historically, I at least have some insight of what could happen (if history repeats itself). Past performance is of course never a guarantee nor a real indication of the future but I have to use the information at hand along with my own judgement of what the future scenario might look like for this investment.
5. Do I have the financial capacity to take this risk?
I will look at different potential scenarios as well as the worst case to determine if I have the financial capacity. Of course, I will never make an investment where I can’t handle the worst case scenario. Different scenarios can be defined differently but if I were to invest 10,000 USD and there is a risk I might (worst case) lose it all, I would not invest if I knew I couldn’t afford to risk the money. So if I know I might need the money in the near future, I would not take this kind of risk whilst I might be ok with a low risk investment in the shorter time horizon. The financial capacity one has is completely individual and should be the base of the unique circumstances.
6. Am I willing to risk this money
It is one thing to have the financial capacity to take the risk of an investment but it is a different thing to be willing (and comfortable) to do so.
A good question to ask is: “If I do this investment, will I still be able to sleep like a baby at night?”
If not, perhaps it’s not the right risk level for me. If you feel you have to follow up on your investment constantly, get anxious and stressed with every movement, most likely you are not investing according to your risk profile. You should be happy with your investments as well as the risk you are taking and not constantly worry about them.
One great way to handle this is to invest the money you don’t think you will ever need, or at least not for the coming 10 – 20 years. If that is a call you have made, you probably won’t feel that you have to follow your investments continuously (as long as you have decided upon a strategy). Allocation and diversification is of course instrumental to having a portfolio and a risk and return profile that suits you. The great thing is that there is something for all of us and in the end it is just about the risk / reward and we make those calls.
7. How does this investment fit with my investment profile and my overall risk profile?
Every investment should be looked at on an individual basis (unless you buy a collective investment like a mutual fund or an Exchange Traded Fund etc.). When you understand the potential investment and its risks you also need to make sure that it is suitable to you. Similar to what I wrote above, you have to feel that this investment is in line with your investment profile as well as your risk profile. You have to feel that the risk as well as the potential return make sense to you. If you are normally a very conservative investor who doesn’t like to take much risk at all (opting for cash/bonds), you should probably not invest in single stocks linked to the commodity sector.
For arguments sake, let’s say you bought a stock like British Petroleum (BP). Let’s say there is another severe oil spill and the share price drops 55% like it did in 2010. If you had invested 20% of you money and the value halved, your portfolio value would have dropped with 10%! With a cash/bond portfolio, maybe a really bad year historically has been minus a couple of percentage points and now your portfolio would show a loss of 10% within two months! Of course there are always exceptions but you have to feel comfortable with the decisions you make and make sure that they resonate with you.
This example also shows the importance of spreading the risks by buying different securities, so if one happens to fall this much in value, it would only have a small impact on your portfolio value and not 10%!
8. Does it fit into my portfolio and what value does it add?
Every investment will be part of your total assets (investment portfolio). Therefore it is very important that you understand how this particular investment will affect your portfolio. If you normally invest very conservatively but want to increase your potential returns, maybe stocks would be a good alternative. If you are adding this as a new asset class (you have no previous stocks), you might want to buy a broad index using an Exchange Traded Fund (ETF). You will then get the new asset class into your portfolio at a low cost and the risks will be spread as you bought an index (collective basket of stocks) instead of one single stock like BP in the above example.
Every investment you intend to bring on, should be adding value to your portfolio. It could be by diversifying the risk in the form of a new asset class, different sectors or geographical exposure. If you only have one asset and buy more of that, of course your risk will just get bigger and bigger and more and more concentrated towards that asset.
This point is of course linked to the previous ones so the investment should not only make sense from different aspects but also, like a piece of a puzzle, suit your portfolio based on your investment goals.
9. What is my investment horizon and current outlook?
Depending on the investment you are looking at, you also need to know what your investment horizon is and possibly have a view of where we are in the business cycle. Do you intend to keep the investment for a short period of time or for many year?. For most of us, the longer the investment horizon, the more risk we are comfortable taking and the less we might take the business cycle into consideration. Instead we tend to focus on the quality of the investment over the long-term.
We know that some assets, like stocks can fluctuate a lot in value in very short period of times but also go down and stay down for years. So if one might need the money in the short-term, I would personally not invest in risky assets like stocks. What history has shown is that over very long periods of time (10 – 20 years), stocks have on average been a very good investment even though they might have fallen significantly during some periods. One big exception here might be Japanese stocks which fell decades ago and they still haven’t recovered so you must make sure you understand the risks you are taking!
Some sectors are more sensitive than others depending on where we are in the business cycle and as an investor you should always have a view on where we are in the cycle. Regardless of the investments you intend to make you might want to do them a bit differently depending on the outlook you have on the economy and in particular the sector you are looking at. You might be less concerned with this if you have a broad and diversified portfolio but the better you understand the economy, the better calls you will be able to make.
10. What are all the cost associated with this investment?
It is your money so you have to know where it is going and how much things are costing you. This might be even more important with investments and especially if they are intended for the long-term. High costs and annual fees will have a very significant impact on your returns. There are numerous studies showing this so one has to understand what all the costs associated with an investment are and then make the call whether or not to invest. Never invest in something where you don’t feel comfortable with the costs or you feel that you don’t even know all the costs!
A rule of thumb is that if you pay 3% per year in total fees and compare it with someone who pays 1%, over a very long period of 30 years (like pension money) with return before fees of 8% per year, the person paying 1% will have roughly TWICE as much money as the one paying 3%!!
I have numerous sessions on this topic and the importance of understanding your costs so make sure you are on top of them at all times!! Check out this post Are you giving away HALF your Pension (in investment fees)?
Another thing to have in mind is to be a bit cautious before investing in the stocks of your employer as you already have a risk towards that company by being employed by them. A clear example of what can happen is Enron. The company went bankrupt and many employees also owned company stocks and had company pension there too. When the company went bankrupt, they lost it all! I would recommend you not to concentrate your risks like this but instead diversify.
Once I have answered all of the above questions and if I am happy with my answers and feel that the particular investment suits me and my investment profile, I might just invest!
What to do now?
- Make sure you save the above questions so that you always have them with you.
- Go through all of your current investments using the above questions.
- That includes any and all pension investments, especially the point on fees and costs!
- The more frequent you use these questions, the more they will become part of your routines.
- If any of these points are unclear, check out my training sessions under the Wealth Section
The more you ask, the more you get to know and the more knowledgeable you become, the more opportunities you will see and be able to act upon!
Actions to take:
- Use this post to get you started: The Bucket System – Automating your Finances
- Go through the Wealth Section and all our free training sessions
- Learn the Language of Money – a language for life
- If you are unsure about any financial jargon, check out our section The Money Language
- Passive income and why you must care!
- Why Warren Buffet Recommends Exchange Traded Funds (ETFs)