The Six Things you Need to Know About your Investments
One thing you the modern investor is never short of is information. We are bombarded with data from every side: share prices, earnings reports, economic forecasts, national statistics.
A lot of this can be useful. And some canny traders can make money by surfing this tsunami of information. But for many of us it is overwhelming. We have so much data we can't understand what's going on. Investing rationally is hard enough without making it more difficult for ourselves.
The only way an regular non-professional investor can cope is by focusing on the key things you need to understand about any investment asset. Here is my list of the questions to ask yourself about the assets in your portfolio.
1. How Does the Investment Make Money?
I mean this in the simplest possible sense. What have you paid for and what do you expect to get in return?
Have you bought part of a business, so that you will receive some of the future profits? (Which is what happens when you buy a share.)
Have you lent money to a business or financial company who will invest it to make money and pay you back with interest? (This is what happens when you buy corporate or government bonds or put money on deposit.)
Have you bought something in the expectation that it will go up in value so you can sell it for a profit? (This is what happens if you invest in gold or other commodities.)
You should also understand this about your particular investments. For example if you are buying shares in a company how does this company make its money? Or if you are buying a fund that invests in a broad index of shares, what markets and economies are those companies collectively invested in and influenced by.
Understanding this will allow you to sensibly analyse your investments, the kinds of risks they have and how they might be affected by changes in the wider economy.
You might also want to understand the different factors that explain the return you get on your investment.
2. What Could you Lose?
No one likes to think about the downsides of their investments, but understanding exactly what they are is a really important tool in managing your portfolio and ensuring you don't end up completely broke.
With some investments your capital is at risk - if you buy shares in a company which then goes bust you will get little or nothing back. Similarly with corporate bonds, if the issuer defaults you may not get back as much as you put in.
Deposit accounts on the other hand usually protect your capital - your main risk is on missing out on bigger returns from more "exciting" assets. Even then there is a risk that the bank or other institution will go bust and not be able to give you your money back when you ask for it, but in many countries there are compensation schemes run by the Government or financial industry which would pay out all or some of your money back.
It's worth understand how these compensation schemes work. For example there may be a limit on compensation per bank, which might mean it's worth spreading your money between a few different banks just to be sure.
And don't forget the effects of inflation. Even if you get back the same amount of cash that you were expecting, if it doesn't go as far on the weekly shop as you expected you still lose out.
3. How Does the Investment Pay Out?
Broadly speaking there are two ways you make a return on an investment asset - income and capital gains (also known as growth). The distinction between the two isn't always obvious but perhaps one easy way to think of it is this: income is money paid to you by the people you invested with, capital gains is what you get when sell some or all of the invested in.
For example, if you own a share in a company, the dividend they pay you is income. Any gain (or loss) you make in selling the share is capital growth. Both are related to the performance of the company, although the divident is under the companies control (assuming they have the cash to pay it) whereas the capital gain is determined by the market.
Some investments pay only income and have no capital growth, such as savings account in a bank, and others have only capital gains (or losses) and no income, such as buying gold or other precious metals. Other investments, such as commercial property, can get both kinds of kinds of return.
Different sorts of return might suit different kinds or investors, or investors at different stages in life. If you are looking to build a pot you won't touch for a while you might prefer capital growth. On the other hand if you need to live off your investments you might prefer income.
4. How Easy is it to Get Your Money Back?
It's all very well making lots of money in an investment, but what if you need that money and can't get it? Some investments are easier than others to turn into ready cash - this is known in the technical jargon as "liquidity".
Some investments need to be sold in order to turn them into cash. How easy this is depends on whether there are enough ready buyers. Sometimes if you need to sell in a hurry or have a lot to sell at once then you might have to accept a lower price (and hence a lower return).
For others, such as some deposit accounts, there are explicit charges or time limits that apply before you can get your money back.
Generally you get a higher return if you are willing to accept less liquidity but you may want to make sure you have enough savings in an easily accessible form so that you avoid losing money when cashing in things too quickly or before they have matured.
5. Is the Return You Expect to Make Worth the Risk You Have to Take to get it?
Broadly speaking, when investing, if you want higher returns you have to take more risk with your money, and if you want to reduce your risks you have to accept a lower return.
In other words there is no such thing as a free lunch. So make sure that the lunch you are buying is what you are happy eating - and that you get good value for what you spend. You need to be diligent in looking at your assets to make sure that you getting the full reward for the risks you are taking. And make sure that you are happy with the risks you are taking (see question 2. above for example).
6. Does it Suit your Needs?
This is the crucial question. The other questions are only useful because they help you answer this. Once you understand enough about how your investments work and the possible scenarios for them, you can use that to decide whether they are working for you and your requirements at this stage of your life.
There are some stages when you might need stability and security. At other times you might be able to afford to take a few hits in exchange for better long term growth. Some people prefer the buzz of taking risks and winning (or losing) big. Others prefer to go slow and steady even if it means missing out on a few chances.
The answers to these questions depend on you and your circumstances, but if you understand how your investments work, you'll have a much better chance of knowing how they're going to work for you.