If you’re a frequent reader of our Knowledge Base , you would know that several of our articles urge you, and advise you how, to start saving more. But we also pointed out in What Are Savings? that you need to separate what you set aside for short-term uses from your savings pool to meet your longer term goals (think retirement, for example).
Our Invest Wisely section focuses on what you could do with the surplus funds you accumulate for your medium-to-long-term goals. In other words, we are referring to funds that you have no reason to touch to meet current or expected expenses.
This article will cover some of the general principles small, individual investors should follow when making investment decisions. Some of these were identified at high level in Cari$ Rules for Financial Freedom, but we’ll discuss them in more detail in this article.
Firstly, let’s explore some general concepts:
- 1 What is Investing?
- 2 Who are “Small Investors”?
- 3 Principal investment classes
- 4 Risk versus reward
- 5 Can you handle the roller coaster?
- 6 Avoid investments you cannot understand
- 7 Pros and cons about salespeople
- 8 Sounds too good to be true? Walk away
- 9 Embrace the magic of compounding
- 10 Reduce or eliminate fees or expenses
- 11 Historical performance is just that, history
- 12 Invest in your own development
- 13 Own your decision
What is Investing?
We view investing as taking decisions where your primary objective is to make your money work for you i.e. your focus is to obtain a return and ultimately grow your money. If you are saving for a short-term goal (e.g. a vacation or deposit to buy a car), these are not funds that you should target for investing. Instead your primary objective would be safety and accessibility. This does not mean you aren’t necessarily interested in a return; it’s just not your primary objective.
In addition, if you are trying to create an Emergency Fund, these are also not funds that you should target to invest. Remember, an Emergency Fund is to meet expenses that will occur in the future but the timing is just uncertain (see Build an Emergency Fund for more information). In this case, your primary objective would be to keep it safe and relatively accessible.
It is, therefore, necessary to understand that we view investing as occurring only when you have genuine surplus funds. Your approach to invest may be conservative, for example, you leave it in a bank or money market account. Or it may be more aggressive where you search for ways to earn a higher return.
Who are “Small Investors”?
It is also worth understanding who are the “small investors” we refer to in this article. Simply put, we are not referring to persons who have sufficient wealth that they can hire a professional manager to help them with investing decisions (these are commonly referred to as high net worth individuals). Our focus is on individuals who are starting to accumulate, or already have accumulated, surplus funds and are trying to make a wise financial decision about their money.
Small investors are at a disadvantage when compared to financial institutions (who make investments) or persons with sufficient wealth that they have easier access to specialized advice. They are disadvantaged in access to information, access to markets, and ability to negotiate or influence prices. This is a reality of all markets and one that all individual investors must recognize and work around.
Principal investment classes
Lastly, let’s cover the major types of investments, often referred to “asset classes”. The classical breakdown is:
- Cash and liquid instruments (sometimes collectively called money market instruments), which would include bank deposits, savings and chequing accounts, term/fixed deposits and treasury bills
- Equities (ordinary or preferred shares of companies)
- Fixed interest/income instruments, which would include government or corporate bonds and mortgages
- Property, which includes direct investments in real estate or indirect investment in listed property vehicles such as REITS
In case you were wondering about what other types exist, examples include, art, commodities (oil, gold, etc.), derivatives, etc.
As you can tell, several instruments could make up a class, and the logic is each instrument within a class has a similar risk profile, but the risk profile of each class is different. Understanding what asset class you’ve invested in helps with managing concentration and tailoring investments to your risk profile, which are points we’ll return to in a bit (as well as in specific articles). We’ll also cover the various investments in more detail in future articles, so don’t worry if they sound unfamiliar now.
With this lengthy introduction, let’s dive into some of the guidelines small investors should follow when making investment decisions.
Risk versus reward
This is probably the most important principle: a low risk investment will earn a low return; the higher the risk, the higher the potential return. Consequently, relatively safe investments like treasury bills and bank savings accounts offer very low returns, while investments like stocks offer higher potential returns but the risk of loss is also much greater.
As an investor, you must decide the level of risk you are prepared to accept, because this would determine your investment choices.
Note: we’ll cover this trade off in more detail in Investment Risk versus Reward.
Do not put all your eggs in one basket
It is worth noting that one of the most effective ways to reduce investment risks is to follow this simple statement, which we’ll discuss in more detail in Investment Risks: A Guide for Small Investors.
At this point, it is also useful to mention the important role deposit insurance plays, but we’ll also cover it in more detail in Investor Protection in Trinidad & Tobago as well as a future article.
Can you handle the roller coaster?
Some investments can move up and down in value (we’ll discuss this in more detail in the article Investment Risks: A Guide for Small Investors). Unless you can handle the emotional roller coaster, keep your principal safe and stay away from volatile investments.
Avoid investments you cannot understand
For your own peace of mind, it is often best to keep it simple and only invest in things that you understand. Otherwise, you are really trusting someone else’s judgement to make a decision. There is nothing wrong or embarrassing about asking many questions about a potential investment until you properly understand it.
Pros and cons about salespeople
Many financial products are sold on a commission-based system, which means the person you speak to will earn income if you buy a product they offer. In principle, nothing is wrong with this system and salespersons serve an important function to increase awareness of financial products as well as assisting with educating potential buyers.
While the majority are trustworthy, unfortunately, there are unscrupulous salespeople whose only objective is closing a sale whether or not it is right for you.
Although companies put safeguards in place to protect you from the few bad apples, the reality is you should not blindly trust anyone who is selling something – listen politely, do your own research, and then make a decision that you are prepared to live with long after the salesperson is gone.
Sounds too good to be true? Walk away
Genuine “get rich quick” opportunities are few and far between, and at any rate, if you are searching for opportunities like these, you are likely gambling and not investing. In which case, these articles are not for you.
A promised higher-than-normal profit or return is usually a strong indicator that higher-than-normal losses are around the corner.
Embrace the magic of compounding
As you invest, your money begins to make money, for example, interest and dividends. It is easy to consider this return as an increase in your spending money, but this is a terrible mistake. Instead, do not spend income from your investments: reinvest and let it compound.
Let’s use a simple example to illustrate: would you rather have $10,000 per day for 30 days or a cent that doubled in value every day for 30 days?
While getting $10,000 every day may sound like the right answer, it is not. $10,000 per day for 30 days will give you $300,000, whereas the effect of compounding in the second option will get you over $5 million dollars, as shown below:
Day 1: $0.01
Day 5: $0.16
Day 10: $5.12
Day 15: $164
Day 20: $5,243
Day 25: $167,772
Day 26: $335,544
Day 27: $671,089
Day 28: $1,342,177
Day 29: $2,684,355
Day 30: $5,368,709
Of course, this is a somewhat extreme example (which assumes a 100% return compounded daily), but over the long term, compounding investment returns is a fantastic strategy. Obviously the benefits are lower over a shorter time-period, so beginning early and sticking with it is key.
Reduce or eliminate fees or expenses
One of the most prevalent investment mistakes is not paying attention to the costs associated with an investment. Many people make an investment and do not even ask what are the costs involved or they only pay attention to the return before expenses are deducted.
The reality is, you can only grow the money you keep; therefore you must understand all costs you have to pay and try to reduce or eliminate them.
Legendary investor John C. Bogle puts it well: “Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns.”
Historical performance is just that, history
When evaluating an investment, it is fairly common to review historical performance (it’s usually the first document a salesperson will pull out). While it is good information, it is no guarantee of the future.
Instead try to assess what the performance could be in the future, or at least ask yourself, if future returns were lower would it change your mind about investing.
Invest in your own development
Do not underestimate the value of investing in yourself, which could occur by:
- investing formally in your education to boost your career, marketability, and earning power;
- investing in time to learn a new skill or obtain new experience; and
- invest formally (take a class or course) or informally (read voraciously) to improve your knowledge and ability to make independent decisions on financial matters
Own your decision
The last point that should be made is that you should own your investment decision and be prepared to live with the good and the bad. Too often when investors make bad decisions they look to others (usually the government) to reimburse them for their losses. Of course, if something is mis-sold, misrepresented, or fraudulent, you have every right to seek compensation. But if you choose to speculate, gamble, or chase an unusually high return and a loss results, you should be prepared to accept the outcome.
We hope this article helped you understand some of the general principles small investors should follow when making investment decisions. Please feel free to share your thoughts or experiences in the comments area below!
This series continues with Trinidad and Tobago’s Financial System. Hope you check it out!
If you believe a financial advisor could add value, don’t hesitate to Contact Us. We’d love the opportunity to assist you.