Rules of Investing – Why & How Much to Invest
Whatever your reason for investing – be it retirement, a college fund for your child, or a major future purchase – it is a good idea to start as soon as possible.
There are some basic ideas you should consider as you get started. Before committing money to any investment, you should ask yourself the following questions:
- What are my financial objectives?
- What is my current financial position?
- How much risk am I willing to take?
- Do I understand this investment?
No matter how much money you are planning to invest, it’s important to have clear answers to all of these questions before you begin.
What Are My Financial Objectives?
The first thing to do when considering an investment program is to determine your financial objectives. Do you want to increase your current income? Are you trying to save for a home? Perhaps you’d like a tax break, or are interested in increasing your net worth.
With these objectives in mind, consider how your initial investment would have to perform in order to meet your goals. High-yield, long-term growth would suggest one type of investment, while reliable, steady income might suggest another.
What Is My Current Financial Position?
An easy way to determine your current financial position is to calculate your net worth. Add up all of your assets, and then subtract your liabilities, remaining balance is your net worth. Following table illustrates examples of assets and liabilities:
|Personal property||Borrowed funds|
|Cash & Bank balances||Credit Card Debt|
|Real estate holdings||Capital – Owned funds|
|Shares & Mutual Fund investments|
How Much Risk Am I Willing to Take?
This is a very important thing to consider. All of us keep talking about returns, but no one speaks about risk. Thinking about risk, different people have different tolerance for risk, and different products offer different risk levels. A fixed deposit is usually much safer than an investment in an equity fund. How much money can you lose without losing your sleep? This is an important question, and you should keep asking this to yourself. You can check our separate guide on how to evaluate risk with examples
Further following are the general risk that one should consider while investing:
- Market Risk: This is the possibility that an investment (e.g., a stock) will decline in value. As a result, if you sold the investment, you would receive less than what you initially paid for it.
- Credit Risk: This is the possibility that the issuer of an investment (e.g., a corporate bond) may not live up to its financial obligations. A default by the issuer could mean that you lose your invested capital and the expected interest payments.
- Inflation Risk: This is the possibility that the value of a long-term asset (e.g., a government bond) may not grow enough to keep up with inflation, reducing your purchasing power as a result.
- Reinvestment Risk: This is the possibility that interest rates will fall when an investment (e.g., a bond) matures or repaid early. If this occurs, you may be unable to reinvest matured assets at the rate of return you were accustomed to receiving. This type of risk also applies to reinvesting the coupon payments received from bonds and other fixed-income payments
- Liquidity Risk: This is the possibility that you will be unable to liquidate an asset (e.g., real estate) when you want and at the price you want. As a result, you may be forced to retain the asset or accept less than you wanted for the sake of liquidity.
- National and Political Risk: The possibility that a country’s government will suddenly change its policies. Events such as wars, embargos, coups, and the appointments of individuals with unfavorable economic policies can impact the financial markets, especially concerning investments related to that country. Possible results include changes in tax structures and changes in bond or stock ratings.
- Economic Risk: The risk that the economy will suffer a downturn as a whole. Such an event generally affects all the financial markets across the board, from product prices to the job market.
- Industry Risk: The risk that a specific industry will suffer a downturn. Often, industries related to the one that experiences problems will suffer as well.
- Tax Risk: The risk that high taxes will make investments less profitable. Such an event may affect entire financial markets across the board, or may be particular industry or segment or just a product.
Do I Understand This Investment?
Just as you would mostly never start a business you cannot understand, the rule applies to investments also. Take the time to understand how an investment works before committing any money. For example, if you are thinking about investing in a stock, you should be familiar with the ways that stocks behave. You should examine research reports on that stock’s performance. You should also ask the advice of your financial professional.
The rules of investing says you must get to know the company you’re about to buy a share of. Reading the firm’s annual report is a good way to find out about the company and the industry it operates in; research reports by professional analysts are another.
Finally after reading rules of investing “In any investment, there are going to be all kinds of factors that happen next week, next month, next year, and so forth. But the really important thing is to be in the right investment.”