There are a number of factors that I consider when contemplating an investment on behalf of my clients or for me, personally.
I think it’s very important to consider a vast array of investment opportunities (or appoint an advisor to do it on your behalf). But it is even more important to discount most of them. Being diligent, setting a high bar and having the discipline to stick to sound fundamentals is critical for success.
This blog sets out the 5 important investment questions that I always consider.
(1) Will it materially improve your financial position 10 years from now?
It is often tempting to invest in ideas or opportunities that may promise to provide quick investment returns. Doing so appeals to our desire for instant gratification (reward). One of my favourite quotes is from Howard Schultz (billionaire and founder of Starbucks); “short term profit rarely creates long term value”. It’s very true.
A quick profit is nice, but it’s not the solution to building long-term wealth, unless you can consistently pick the next short term opportunity. But that is impossible to do. The problem is these ‘quick profit’ opportunities tend to be inherently risky (so many don’t work out well) and provide a one-time return only.
Instead, you are much better off to invest in assets that provide predictable returns over very long periods of time. Investing in an asset that provides an average return of 7% p.a. over the next 30 years will magnify its value by 7.6 times.
Asking yourself whether the investment you are considering will materially improve your financial position in 10 years’ time, forces you to think long-term. It helps you avoid the shiny objects (i.e. opportunities that trick you into believing they’ll deliver quick profits).
Ironically, the older we become, the easier we find it to make long-term decisions. Or maybe we just get more comfortable with delayed gratification. Either way, it requires discipline and patience.
(2) Do you understand what’s driving the expected returns?
Don’t invest in anything you don’t understand.
You need to understand how the investment will work. How will the returns be generated? It must make sense.
For example, if you are investing in a property in a blue-chip and highly sort after location, it is easy to understand how that property will be worth a lot more in 30 years from now. How much more is uncertain, of course. But it stands to reason that its likely to outperform the “average” property.
However, for example, this is my problem with Bitcoin. I understand what it “could” be used for. I understand the advantages of a decentralised currency that offers privacy (anonymity). But the reality is that the vast majority of people currently buying Bitcoin are doing so for pure speculative purposes. Therefore, the only way I can make a return is if it attracts an increasing number of speculators. And that feels very risky to me. I invest. I do not speculate.
All fundamentally sound investments can be explained in simple terms using basic logic. It’s important that you understand this logic. If you are not able to do that, don’t invest.
(3) Where is the evidence?
There is no need to throw darts at a dartboard. There are plenty of investment opportunities (asset classes and investment methodologies) that offer good long-term returns of 8-10% p.a., which are supported by an overwhelming body of evidence.
Therefore, when contemplating an investment, ask yourself where is the evidence that this is going to work. The fact is that such evidence doesn’t exist for poor quality investments. Therefore, following this rule will help you avoid investing in something that won’t work.
Of course, only using evidenced-based strategies doesn’t eliminate all risk. It is possible that past returns are not a reliable indicator of future returns, which is why you must take into account the other factors listed in this blog.
(4) Who’s making money and how much?
Virtually no one promotes investments for free. Often, there’s a commercial incentive to do so. It is very important that you understand what incentives exist, who benefits and by how much. The reason is because you, the investor, ultimately ends up paying for them (through lower returns or lost value).
For example, some property developers pay massive commissions (often tens of thousands of dollars) to people that sell/recommend off-the-plan properties to their clients. When the developer sets the property’s sale price, they include the cost of paying commissions. But you (the owner) don’t receive any value for paying them. Ultimately, you’re the one that is out of pocket.
Commercial interests aren’t bad per se. People should be fairly rewarded for their time and expertise. And you must fully understand who gets paid what, so that you can make this assessment of whether its reasonable or not and what value it’s going to create for you.
(5) What could go wrong?
I find most investors focus on possible returns but fail to consider risks. Instead, I prefer to initially identify all the things that could go wrong and think about ways I can reduce or eliminate these risks. I do that before I consider what returns are achievable.
As Warren Buffett advises, the first rule of investing is to never lose money. Therefore, by thinking about your downsides first, and mitigating them as much as possible, you might be able to achieve good investment returns whilst taking very little risk. This is the real genius to investing well because normally you have to accept higher risk if you want to achieve higher returns. But that is not always true. Focusing on your downside first goes a long way to reducing your risk, thereby helping you to never lose money.
It takes real discipline to do nothing
Global fund manager, Fidelity undertook a study of the performance of client accounts between 2003 and 2013 and found that the best performing accounts were ones that were deemed ‘inactive’ (e.g. people had lost log in details or forgot the account existed). This demonstrates the value of patience (and the fact that our intervention rarely adds value).
You need to have the patience to find the right investment opportunities. And then you need to have the patience to hold onto the right investments for the long run. Do that, and you will accumulate a lot of wealth – albeit it may take a couple of decades.
If you can’t find the right investment, do nothing. Don’t compromise. Just keep looking.