Amateur investors lose their money as they invest based on hunches, tips & calls provided by brokers, internet articles or just because of the herd behaviour. This results in unavoidable and unnecessary risks which causes huge wipe out of the investor’s wealth. The difference between an amateur and a professional investor is that professional investors don’t put a single rupee at risk before doing risk assessment. Surely, it’s a painful, boring and time consuming task but what you don’t know about investing will cost you money.
Following are the questions you should ask yourself before investing –
- How can I lose money with this investment?
“You don’t know an investment until you understand all the ways you can lose money with it.”
The first question in your mind when analysing any investment is to find all the ways you can lose money by identifying in advance all the major risks that can lead to losses. Once these risks are fully identified, the second step is to pro-actively manage away whatever risks are manageable.
- How will this investment help me achieve my personal and portfolio objectives?
The portfolio objective for most investors is to maximize profit with minimum risk. But it’s not enough to just have a portfolio objective – you must also have a personal objective.
“Success with money, family, relationships, health, and careers is the ability to reach your personal objectives in the shortest time, with the least effort and with the fewest mistakes. The goals you set for yourself and the strategies you choose become your blueprint or plan. Strategies are like recipes: choose the right ingredients, mix them in the correct proportions, and you’ll always produce the same predictable results: in this case financial success.”-Charles J. Givens
Investment success is a lifelong process, and humans aren’t robots. The only way you’ll stay the course long enough to succeed is when your investment strategy fits your interests, skills, goals and resources, thus providing emotional satisfaction.
- What’s my exit strategy?
You should always have your exit planned before acquiring any investment. Times change, market conditions change, and your objectives change. You have a reason for acquiring an investment, and when those reasons are violated, it’s time to exit without delay. By knowing your reasons in advance, there’s no confusion or hesitation with the sell decision. Selling is to your portfolio what pruning deadwood is to a tree – it makes room for new growth to occur. It’s healthy. You should never marry your investments.
- How Does This Investment Make Business Sense?
Investing is ultimately about business, so every investment must make business sense. What that means is the earnings, valuation, and return on investment must be congruent with the competitive advantage and barriers to entry possessed by the underlying business. The world of business and finance is competitive. Above market returns and excessive valuations can only be supported if a significant competitive advantage coupled with barriers to entry for future competitors exists. Otherwise, the high valuations and returns will attract competition until returns and valuations are forced down to market level. In plain language, that means your investment loses money – which is a bad thing.
- How Does This Investment Affect The Risk Profile And Mathematical Expectancy Of My Portfolio?
You should never add an investment to your portfolio unless it either lowers your portfolio’s risk, or raises its return. Preferably, you should get both. All investments should first be analyzed for their risk profile (under what conditions they will zag), and their mathematical expectation (how much they should return over time).
My intention is for the above list of questions to serve as a basic starting point for your own due diligence process. I don’t pretend this list is exhaustive because a whole book could be written on the subject.
I’ll end the article with a quote of Erik Falkenstein, “In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”
Chinmay Madgulkar is an Electronics & Telecommunication engineer from the University of Pune. He has completed his MBA in Finance from Xavier Institute of Management & Research and is a Management Trainee - Equity at Taurus Mutual Fund. He is also a Mutual Fund advisor. You can read all other posts by Chinmay on InsideIIM.com here.
You can connect with Chinmay on LinkedIn here.