26 October, 2020

HOW TO AVOID BAD INVESTMENTS

The phrase “bad investment” is such a broad term that I will spend the next few paragraphs breaking it down as much as possible. 

I’ll start by assuming that you have at least a basic understanding of what an investment is:

Putting resources (money) into financial schemes, shares, property, or a commercial venture with the expectation of achieving a profit.

Every investment is risky. There is an inverse relationship between risk and reward when it comes to investing.

The riskier an investment; the higher the return.

However, what differentiates investing from gambling is the rational approach you have to take towards it. 

Everybody has an investment risk profile broadly based on your tolerance of risk relative to your age, income and general constitution.

The major profiles are;

  • High Tolerance Investor(HTI)
  • Medium Tolerance Investor (MTI)
  • Low Tolerance Investor (LTI)

What is a good investment for an LTI might be a terrible investment for an HTI and vice-versa because when it comes to investing, apart from the benefits or the returns, you also have to consider lost opportunities (opportunity cost).

So what is a bad investment? 

I would define it as one that doesn’t hit your full potential based on your risk profile.

As an LTI if you invested in mutual funds that aggregate hospitality companies at the beginning of 2020 hoping to make a 9% return, and now due to the COVID-19 pandemic, those companies are not doing so great, so you are hovering between 3-5%, that’s undeniably a bad investment. 

But it’s not only a bad investment when you lose real money. There is also the consequences of choosing the wrong investment vehicle for your risk profile. 

For example, As an HTI you invest in mutual funds which aggregates the top tech companies in your country because you notice there has been growth in the tech sector and you would like to take advantage of that. You make a tidy profit of 11% per annum. This is undeniably a good thing; not only did you not lose your money, you made a return on the investment. Is this a good investment though? Let’s examine the opportunity cost:

You are an HTI, so you most likely have a relatively high net worth or at least high income. You are also young, active and probably have a high-risk tolerance. If you chose to invest in a tech-focused mutual fund during a tech boom, it means you also have a good knowledge of analysing investments and if the mutual fund you invested in returned 11% at the end of the year, it means that many of the individual companies in the fund did well. 

All this means is that if you had done a bit more research and analysis, you would have invested individually in a good company which while riskier would have made anywhere from 30-150% return on your investment.

For an LTI, 11% is an amazing return, but for an HTI, you left too much money on the table so I wouldn’t call that a good investment and the opposite of good is bad so…

The question now is how can you, regardless of your risk profile, avoid bad investment decisions and vehicles?

  1. Understand your risk profile: Risk profiling is not an exact science, but there is enough information online for you to do a personal assessment and understand exactly the amount of risk to expose yourself to at your current stage in life. Once you have that information, you can now begin to make investment decisions that match your profile

 2.    Research, Research, Research: For every single investment opportunity that comes your way, make sure you conduct extensive research on every single aspect of the deal. You should ask questions like:

  • Are the people behind it trustworthy?
  • Is the opportunity a reasonable one?
  • Do I even understand this at all?
  • Is the promised return realistic?
  • How high is the commission I have to pay?
  1. Diversify your portfolio: Your investment portfolio is the collection of all your investments from ETFs to Mutual funds to Stocks, Bonds, Real estate etc. It is always a prudent choice to diversify your investments across all the different asset classes available in a way that reflects your risk profile and your financial goals. There are various formulas for the best way this mixing can be done, but make sure you speak to a financial expert to help you decide the best way to go about it.

4.  Stay informed: People gain access to great investments or avoid bad investments just by being aware of some seemingly random information. For example; the Lagos state government in Nigeria has declared parts of Ibeju Lekki (Not to be confused with the popular Lekki area) a free trade zone and is investing significant resources in the area – an airport is being built there, seaport, as well as infrastructure, is being put in place for what they are calling a new Lagos. This effort went into full gear in 2002. However, people with the right information had already secured pieces of land there before the government announced plans for the place.

On the flip side, people who invested in property there but failed to secure their rights or failed to buy from the right sources have lost their properties and along with that, the money invested, definitely a bad investment.

  1. Have the right attitude towards investing: All investment comes with risk. The element of risk is what creates investment opportunities. It’s important to bear this in mind while investing. It is not a gamble or a game of chance and you should approach the opportunity with the solemnity it deserves, and this means accepting that there is a good chance that you lose your initial capital but taking all necessary measures to protect yourself from this.

Your job is to reduce the chance that the investment will go bad, not remove it completely because that’s just not a possibility.

Bottom Line

Investing is a risky activity. However, when managed properly, it is very rewarding. Investment risk is not only tied to how much you stand to lose but also how much you would have gained if you had made different choices. 

Every investor should understand all the risks involved with every opportunity and take the necessary steps to protect themselves.

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