Fundamentals 101 – Criteria for Determining Your Ideal Investment
Most places talk about different investments you can make and talk about it based off of potential returns and risk, which is a very dangerous thing to do.
What they have decided to omit are the other criteria that are equally as important, which we will cover here.
But before we get into those, it's important to understand why we need to take in consideration of other things. The biggest reason is that your finances is only one part of your life, and should play a role in helping you live a better life.
What it should never be is the main source of worry, which is why it's important to understand all the different aspects of how the investments you choose will impact the way you live.
That said, let's dig into the different criteria for determining your ideal investment.
Criteria 1: Return
The whole purpose of investing is to have your money compound to become more money in the future. And the best way to determine how much that money will be worth is based off the return of the investment.
The higher the return, the more money you will have. Simple.
But if you only used this criteria, you may be in for a very difficult life.
The other criteria will show you why.
Criteria 2: Risk
As the saying goes, the higher the risk, the higher the return.
It is in general true, but it is possible to find investments that go against that statement.
Risk here is defined as the chances that your investment will lose you money.
The reason why in general that higher returns are typically connect with higher risk is because if the moment the company has a higher chance of being successful and making a lot of money, there would be thousands of people wanting to buy into that company, which would drive the price up.
So if you were to buy anytime after that first hour, you would have already lost all the high returns.
Using a bond as an example, a government bond will typically give a much lower return than a company bond because the risk that a government will go bankrupt is much lower than a company.
Similarly, that's the reason why P2P investments also have much higher expected returns – because you're not hoping that the small business that you lent money to will be able to pay you back with interest in the future.
Connecting risk to your life is the potential emotional roller coster you will go on when you invest in something risky. On some days, you will worry about your investments losing you all your money that's meant for growing the life you want. And on other days, you will think about all the additional things you can do because your investments are doing better than what you were hoping for.
Although these are typically the 2 criteria that's looked at when talking about investments, there are other things to consider.
Criteria 3: Time / Energy
We briefly mentioned that it's possible to find higher return potential at a much lower risk. But in order to discover those, you will have to now invest something else that's not money.
That investment is time and energy – two resources that you can never get back.
The really successful people you hear on the news never started off with all that success. They spent decades perfecting their craft, learning to manage their emotions, and spend countless hours each day getting better and better at it.
Then you have a whole industry who pay some of the smartest people to work for them in order to find these opportunities before everyone else.
Will you be able to compete to find these companies against such big organizations and teams? Are you willing to spend 10+hours a day for years, with the high chance that you won't reach any major breakthroughs?
Or would you rather spend your time and energy doing things you love?
Criteria 4: Diversification
Just because something is doing well the last few years, doesn't mean that they will continue to do well in the future.
Every sort of investment has its strengths in terms of when it will do well and will have its weaknesses (during times it will do poorly, and even go bankrupt).
Look no further than what happened in 2008. Before 2008, stocks and real estate were booming. People were able to buy pretty much anything and have it go up in price the next year.
However, after the 2008 real estate bubble popped, not only was real estate impacted, but so were companies all over the world. Banks that were deemed impossible to go bankrupt were struggling to stay alive.
House prices fell so much that for some people, the loan they had on the house was worth more than the house itself.
Millions of people around the world lost their job.
And if you were invested in any stock or real estate, you probably saw a 50%+ drop in price within a 1 year period.
But during that time, investments like gold and government bonds were in high demand.
If you were already invested in those, you would've made a lot of money.
And that's the importance of diversification – you don't know what will happen to the economy in the future so you should always try to stay diversified.
Criteria 5: Fees
The last main criteria to understand is fees.
Fees is usually a tradeoff between time/money and return. The idea here is that you would be paying someone or some company to manage your investments, and in return would pay a fee for that.
However, if you were to go back to the concept of compound interest, fees are are similar to interest, except that you lose money over time instead of gaining money.
A simple example is this. Say you pay some company to handle your investments. You pay them 2% a year for this service. Over the course of 30 years, you would have 80% less compared to if you were able to do it yourself (and get the same returns).
So the question isn't if you should pay the fees, but does paying the fees increase your actual return by more than that fee. If not, you should look at an alternative.
That said, let's dig into the 3 main types of stock investment using these 5 criteria.
Investing in an Index Fund
An index is simply a way to benchmark how well something is doing. That said, KLCI is the index that determines how well the Malaysian stock market is doing, whereas S&P500 is the index that determines how well the top 500 stocks in the US is doing.
Because an index is literally just an index, you cannot directly invest into it. So that is why people have created an index fund. The purpose of the fund is to mimic the index by buying the right percentage of each company that is in the index. That way, as the index moves up and down, the index fund will naturally move up and down.
The best way to invest in an index fund is through something called an exchange traded fund (ETF). ETFs trade just like a stock, except when you buy an ETF, you are buying a small part of the index fund instead of a specific company.
From a return perspective, the index fund is gonig to go up and down similar to the index. In the US, the S&P500 index has given on average, a 10% return each year.
From a risk perspective, by buying into an index, you are in a sense, buying a part of every company under that index. That means the risk is that all the companies in the index do poorly, which is much less likely to happen than buying one specific company.
From a time/energy perspective, buying into an index fund is the least amount of work needed. You would simply buy into the index fund via an ETF and you are done.
From a diversification perspective, buying into an index means buying into all these companies. You are definitely a lot more diversified than buying one specific stock, but you are still only as diversified as the index itself. For example, if you but the KLCI, you are diversified in terms of companies in Malaysia, but would have no companies in China / US.
And finally, form a fees perspective, this is slightly more than buying your own stock, but a lot less than having someone manage it for you. Fees can be as low as 0.05% each year, which means giving up 16% over 30 years.
An index fund is what we recommend most people to go with as it has the lowest fees while still giving some of the best returns.
Investing in a unit trust
A unit trust is known as a mutual fund in the US. A unit trust is similar to an index fund in that there are multiple companies, but the difference is that the purpose of the unit trust is to do better than the index (otherwise, why pay someone if you can easily buy into an index fund yourself).
Unit trusts are focused based off what they have told the investors. For example, let's say there's a unit trust that focuses on investing in tech companies in China. That means the unit trust can only put money into companies that fit that criteria, and would not be able to put money into facebook.
From a returns perspective, unit trusts can be all over the field. Most will do worse than the index, and 99% of them will fail to beat the index over the long term.
From a risk perspective, unit trusts are run by professionals whose job is to stay on top of all the news in the world. That said, they will probably have less risk compared to if you were to do it yourself.
From a time/energy perspective, buying into unit trusts can be easier than buying into an index fund just because there are so many salespeople who can do everything for you. You just need to tell them what type of fund you're looking for and they can show you what's possible.
From a diversification perspective, unit trusts are similar to index funds in that they will have multiple companies inside the unit trust, but will still be limited in diversification based off their mandate. So if you bought a unit trust focused on tech companies in China, that's all you will have.
And finally, from a fees perspective, unit trusts have really high fees relative to index funds. Most unit trusts have fees to buy them, and then there are ongoing fees. Let's just say that there is only ongoing fees of 1.5% each year. That means after 30 years, you would have given up 56% of your money.
We would suggest a unit trust if you are unable to buy index funds for the diversification you're looking for.
Investing yourself can be a lot of fun, a lot of work, and comes with a lot of emotions that you'll have to learn to deal with.
This is something that we would not suggest you do unless you love looking through reports, numbers, and articles about companies.
Returns: hard to quantify
Risk: much higher than everything else until you master a specific type of investing / trading methodology
time/energy: expect to be putting hours each day for decades
Diversification: you will have to learn multiple industries in order to diversify properly; otherwise, you will probably not be diversified.
Fees: nona besides your trading fees from your stock broker.