Learn the Basics of How to Invest Your Money
When you have saved more money than you expect to need in the foreseeable future, consider investing this money to earn more interest than what your savings account is paying you. There are many ways you can invest your money. Before you can narrow down all of the choices, you need to consider four basic points:
- How long will you invest the money for? This is called your Time Horizon.
- How much money do you expect your investment to earn each year? This is your Expectation of Return.
- How much of your investment are you willing to lose in the short-term in order to earn more in the long-term? This is called your Risk Tolerance.
- What types of investments interest you?
Once you have considered these four points carefully, you can begin your research and decide what you're going to invest in. Trusting someone else to do the research for you adds some risk as you are relying on their expertise. And remember, no one is more interested in your money than you are.
1. Determine Your Time Horizon
When you decide to invest your money, you need to figure out how long you plan to invest for. You may not be able to come up with an exact number, but you can probably estimate whether you will be investing for one year, three years, five years, ten years, or longer. Plans can change, but the important thing is to make a plan. If you can’t figure out roughly how long you think you might invest your money for, then you probably shouldn’t invest.
The reason why you need to know your investment time horizon is because different investments behave differently. If you only plan to invest for one year, but put your money into the stock market, you may be very disappointed if, all-of-a-sudden, the stock market drops and you lose 20% of your investment. It may take the stock market many years to recover what you lost, and if you only planned on investing your money for one year, you will be out of luck. You can see that someone who only plans on investing for a short period of time should stay out of the stock market. The stock market typically requires a long time horizon—ten, twenty, or thirty years—so that your investment can weather the ups and downs and eventually generate a good return for you.
People who are looking to invest their money for a short period of time (less than a year or two) and want to have it very accessible in case of an emergency will usually put their money in a high interest savings account, a term deposit, GIC, or money market funds. Investors who are looking to invest for three to five years may also consider investing in bonds, bond funds and other fairly conservative investments that pay interest. Those who are looking to invest for a decade or more often move a substantial portion of their investments into the stock market, real estate or other investments that have potential for higher returns but are not always easy to liquidate (sell) or may experience downturns that can last for many years.
2. What Are Your Expectations of Return?
When you invest your hard earned money, how much of a return do you expect to get from your investment? Those who are new to investing will often say, “I want to earn a return of 50% to 100% on my investment—every year.” But is this realistic? What is a reasonable rate of return to expect on your investment? To find out, let’s take a look at a simple illustration of how things usually play out in the real world. Then we’ll come back to the question of what kind of a return you expect.
To begin our illustration, we will draw a horizontal line. Imagine that this line represents all investments known to man; from the lowest risk investments on the far left to the highest risk investments on the far right.
Now for our illustration, we will create some investment categories by drawing some short lines vertically across our long line. We will call these sections Low Risk, Medium Risk and High Risk.
If you were to invest in a high quality investment (as determined by a company’s credit rating), try to guess how much money a Low Risk investment would earn on average over a ten or twenty year period of time (you don’t have to invest for that long, but to fairly compare different types of investments, we want to look at average returns over a long period of time)? The answer would likely range from four to six percent. Now without looking ahead, guess how much of a return a Medium Risk investment would earn on average over a long period of time? A realistic answer would probably fall between six to eight percent. So what about a higher risk investment in quality companies? Over a long period of time, you would probably earn an average of around eight to ten percent.
These numbers assume that you are investing in high quality investments with good companies that have good reputations and good credit ratings. If you want to take your chances and shoot for a higher return, you can do that, but that comes with added risk. Examples of these kinds of higher risk investments would be people speculating by buying shares of small, new companies on the stock market or trading in the commodity futures markets. These types of investments are very risky, and those who consistently earn higher rates of return in these markets typically only do so after many years of experience, research, and learning exceptional discipline. Just like some people pay hundreds of thousands of dollars for a Harvard education, many of these people have lost hundreds of thousands of dollars learning how to successfully trade or invest in these markets. The ones that stick with it and succeed might call the money they have lost, their tuition.
Many people lose a lot of money by chasing after exceptional rates of return. You can usually avoid this trap by carefully looking into every investment you make and carefully consulting with those you trust before you make a big decision. The internet is a great tool for researching companies, individuals, and investment ideas to see what other people’s experiences have been. Don’t just look for the positives in potential investments—any salesman can give you a long list of those. Look just as hard for the negative side of every investment. It is often helpful to find people who have had bad experiences with the type of investment you are considering so you can avoid their mistakes. You should be able to find these kinds of people among your acquaintances, your family’s acquaintances, or online—but just remember to assess the credibility of the websites you glean information from.
3. What is Your Risk Tolerance? How Much Risk Can You Live With?
How much risk can you handle? Let’s look at our illustration again. When most people look at this illustration, they immediately gravitate to the 8% to 10% high risk section. So far, those rates of return look the best. However, when it is pointed out that a return of 8% to 10% is accompanied by the risk of loosing 30% of your investment any given year, many people recoil at that thought and move to something a little less risky.
If you chose to go for a medium risk investment, you are looking at the possibility of losing 15% of your investment on any given year. If that is still too much risk for you, you can opt for a low risk investment. With high quality low risk investments, you can potentially lose 5% of your investment in a bad year, but fortunately, that doesn’t happen very often.
The percentages in this simple illustration aren’t set in stone. These are just rough numbers based on the last 50 years. You could lose more or less than these estimates, but the idea here is to inform you of what can happen—and what will happen from time to time. If you invest in any investment category for a long enough period of time, you should experience some losing years with losses that are comparable to this illustration. However, most people in the investment community generally say that if you hold on to a quality investment for a long period of time, you should earn a good rate of return. No one can guarantee this, but this seems to be the way things have generally worked out over the past hundred years.
If you don't want to expose yourself to any risk, then your safest bet is to invest in government bonds. These pay the lowest rates of return, but they are the safest investments. The next safest investment would be in term deposits from your bank or credit union. An important concept to be aware of is that no investment is without risk. Governments can collapse or lose investor’s confidence, banks can fail, and companies can go bankrupt. When it comes to investing money, there is truly no such thing as a safe investment. Every investment has risk. Some investments have very low amounts of risk compared to others, but no investment can be called completely safe.
In the business world, risk is measured by credit ratings. The better credit rating a business has, the less risky it is perceived to be. Governments usually have the best credit ratings because if they need more money, they can either raise taxes or print more. Large banks are often next in line with the next best credit ratings, and then credit ratings move down from there. Below is a table that illustrates how credit ratings generally compare among different organizations. You will notice that the better credit rating an organization has, the less interest it has to pay to attract peoples' investments. Everybody knows that there is less risk involved in investing in Government of Canada bonds than there is in investing in bonds of public or private companies. Credit ratings reflect this knowledge and so the Government of Canada doesn’t have to offer investors as much interest as a company would because investing with the government investment involves less risk than investing in a company.
Expected Rates of Return Based on Credit Ratings (an objective measure of risk)
|Organization||Rates of Return|
|Government of Canada||Pays the lowest interest rates because it is the safest place to invest|
|Large Banks||Pay higher interest rates because they are not as safe as the government|
|Smaller Banks & Credit Unions||Offer higher interest rates because they are technically not as safe as the larger banks|
|Companies||Need to pay higher interest rates because they are usually not as safe as banks or credit unions|
|Small business and Individuals (Family, Friends and Acquaintances)||Highest risk (banks use credit scores to assign credit ratings to individuals)|
When it comes to people investing their money, many people think that their risk tolerance is higher than it actually is. Most reputable investment companies and investment professionals know this, and so before you invest with them, they will use a number of methods to confirm your risk tolerance to make sure that you aren’t making a choice that you will abandon at the first sign of trouble. If you say that you can handle a 15% decline in your investment, and then you want to get out of your investment as soon as it goes down 5%, no one will benefit. You will lock in a 5% lose and the person who is helping you with your investments may lose you as a client.
Make sure that you will be able to sleep at night with the investment choices that you make. A good investment professional should be able to help you with this, or you can do some thorough research into your investment choices to put your mind at ease.
Here are some final thoughts on risk:
- Never invest money that you can’t afford to lose.
- If something seems too good to be true, it usually is. Sometimes good opportunities are only available for a limited time, but that is no reason to rush into them without taking the time to carefully investigate them. If your research shows an opportunity is worth-while but the time to act as past, don't kick yourself. Look for another good opportunity. You may have to be patient, but you'll eventually find another great one.
- Always consider what the worst case scenario could be with every investment decision that you make. The riskier the investment you choose, the higher the odds are that a worst case scenario will occur, and you will lose a lot of money.
- Don’t put all of your eggs in one basket. Make sure that you diversify your investments.
4. What Kinds of Investments Interest You? How to Profit Off Your Interests
Many people think that investing is boring. They invest because they know it is a good idea, and they want their money to grow. If you ask people what they are invested in, a lot of them will say something like “I don’t know. I think it might be something like . . .” Many people don’t know because they just leave their investments in someone’s hands and hope for the best.
There may be a better way than just hoping for the best. Would you be surprised to learn that almost all successful investors not only know what they are invested in but usually take an interest in what investments they choose?
Millionaires' Secret to Investing
Two professors conducted a twenty year study of America’s millionaires and wrote a book called The Millionaire Next Door. Two things they found that most millionaires have in common are that they like their jobs, and they invest in the industries that they work in. So these millionaires are investing in an industry that interests them, and they are paid to follow it closely—because it’s their job. Consequently, they know who the winners and losers are in their industry, and they can see who will likely do well in the long term and who is probably headed for trouble. When these millionaires invest using this knowledge, they get really good results because they know what they are doing. This isn’t rocket science. It just makes sense.
How You Can Use the Millionaires' Secret
So if you work in the retail industry, do you notice the companies who are doing things better than your company? Do you notice that these companies are innovating and consistently doing things right? Do you see them becoming much stronger players in your industry in the future? Are these possibly good companies to invest in? If you work in an industry, you should know the answers to these kinds of questions. You should be able to spot trends and identify the best companies sooner than any one else because you spend every workday in your industry. No one else can spend this kind of time getting to know an industry. Do you see how you can potentially use this knowledge to guide some of your investment decisions? You may also be positioned to glean some good insights into other industries that are related to yours. Talk to your suppliers, clients, colleagues, and others you come in contact with. Most millionaires get rich just focusing on their industry. You can employ the same strategy and increase your net worth too (just make sure that you obey the law and don’t violate any of your industry’s ethics guidelines—we are not encouraging insider trading—investing in your industry is very different to buying and selling stocks based on privileged information).
If you follow what we're saying here and research and invest in your industry and/or other industries that you care about, it could have some unintended consequences. As your expertise grows and you become more insightful and aware of what's going on, this may lead to a promotion, a delightful new career track you couldn't have anticipated, or even a business of your own.
This concept of investing in what interests you can be taken beyond your occupation. Besides your job, what sorts of other things interest you? Are you interested in cars, computers, fashion, music, travel, or something else? You could consider investing some of your money in other things that interest you. If you love cars and pay attention to the automotive market, you may have figured out a long time ago what car companies were positioned to do well and which ones were headed for trouble. If you are really in to computers, you may have foreseen Apple’s success. If you love to travel, the growth of the cruise ship industry and eco-tourism may not have been surprising to you. If you are really interested in something and follow that industry, you will gain a strong sense of who the up-and-coming stars are and who are the falling stars. You can put this kind of knowledge to work in your investment portfolio and make some money off of what you are already interested in. Millionaires do this, so why shouldn’t you?
How Investing in What Interests You Helps Your Entire Investment Portfolio
There are plenty of other advantages to investing in what interests you. If you find some of your investments to be very interesting, you will probably check up on them more often. While you are at it, you may look and see how the rest of your portfolio is doing compared to your favourite investments. Paying attention to your investments like this will probably help the growth of your whole portfolio in the long term.
Many people don’t make changes in their portfolios at the right times because they are waiting for someone else to tell them what to do. Unless you have hundreds of thousands or millions of dollars to invest, no one is going to call you up and tell you that you should move some of your money out of one area and move it to another (if your investment person does this for you, you’re lucky). If you, however, are following an industry on your own, you will be able to see when the winds are changing, and sense when it is time to move around some of your investments. Having said this, it usually isn’t wise to make big changes to your portfolio on a frequent basis. Any decisions you make should be long term. Although it is wise to check up on your investments every once in a while, for most people, it is best to make a good decision and then stick with it until you believe you have reached your target or there is some thing significant that has persuaded you to change your mind.
Investing successfully is a learned skill. No one is born with it. Take advantage of the knowledge and expertise of others as you learn to make wise investment decisions, and never put all of your eggs in one basket. Never invest all of your money in one industry or in one company. Everyone is wrong at times, and if you are wrong, you don’t want your mistake to devastate your portfolio. Exercise caution and prudence and listen to the advice of others you trust.
Consider these points if you ask someone to help you with your investment decisions:
- What is their track record?
- Have they been doing this for a long time? If they haven’t, then inexperience can be costly. Are you willing to learn with them and finance their education with your investment dollars?
- Does your investment advisor have a solid track record of consistent returns for clients? How did your investment advisor’s clients do when the market crashed? Were they prepared for that event? Don't accept the excuse that no one can anticipate market crashes. Anticipating danger and avoiding it's full impact is what every professional is expected to do in almost every profession.
- What is their motivation? How are they paid? Do they do well if you do well, or do they make money even if you lose money?
- Does what they say make sense to you? If an investment advisor sounds great, but you don’t understand anything that they say, then you are taking on more risk. You will now have to completely trust this person because you have no idea what they are doing. Entering into this sort of situation may not be in your best interest. Invest in what you understand.
- Do you trust this person? Do you have some good, solid reasons to trust this person? Do they have a good reputation? What did their references say about them?
These are all things that you should consider. However, unless you have a lot of money to invest and are willing to do a lot of research, it may be difficult to find an investment advisor who meets all these criteria. But, if you ask these questions and evaluate an investment advisor along these lines, it will only help you to make a better decision.
However you chose to invest, you can substantially reduce your risk by diversifying your investments.
"Diversifying" is the sophisticated way of saying “don’t put all of your eggs in one basket.” As anyone who was watched the news over the last decade will know, no investment does well all of the time. Every type of investment will experience ups and downs. Since 2000, we have seen the greatest bull market in history followed by two global stock market crashes. This was followed by one of the greatest real estate buying frenzies and collapses in history for the U.S. and other nations. If you had invested all of your money in stocks or real estate that was affected by these market collapses, you could have lost a lot of money.
Diversifying your investments means that you may put a portion of your investments in the stock market, some in bonds, a little in cash (for buying opportunities), and a portion in something else—like real estate. Historically, bonds and stocks tend to do the opposite of each other. The advantage of having both of them in your investment portfolio is that one of them should always be rising. So if one is doing terrible, the other one should be doing well.
The first advantage of diversifying is that diversification reduces the volatility of your portfolio and your risk. When the whole stock market crashes—if only for emotional and psychological reasons—most people don’t like to see all of their investments go down at the same time. The second reason to diversify is it can keep your money working for you at all times. When the stock market is doing poorly, something else should be doing well. This is why bonds have historically been a good way to diversify a portfolio.
For people who truly wish to diversify their investment portfolios and earn a good return when the stock market is not performing well, there are now more choices than ever. Some options can include investing in other countries, investing in resource based companies or investing in commodity index funds. All of these investments have unique risks including the fluctuation of international currencies. You should take great care, do your research, and seek advice before venturing into any of these more complex investments.