Smart investing is a relative approach. It depends on other factors like how close you are to retirement and what type of market in which you invest — such as stocks, bonds, or mutual funds.
The fact is that each of us has unique financial needs, and this will be the case all through our lifetime. This is why we need simplistic approaches to how we invest our money.
Regardless of how we invest in the markets, these three (3) factors will play a major role in our success. You will notice that each of them has a double edge that directly affects your rate of return.
Liquidity
Liquidity pertains to how quickly your investment can be converted into cash. This is more of a concern for younger families because they need quick cash for many reasons, so they tend to need more liquidity.
However, older families that are more financially established who have purchased their last home, and have sent their kids to college, don’t typically need as much liquidity.
Generally speaking, liquidity has an inverse relationship with your investment return. In other words, whenever there’s more liquidity, there’s a lower return on investment. A perfect example of this when you compare returns on basic savings account to a 1-year certificate of deposit (CD). While you can withdraw money from your savings anytime, you can’t withdraw your 1 –year CD funds until after one year — without paying a severe penalty.
You can see the effects of liquidity in the stock market. Stock liquidity is typically measured by the number of shares outstanding and the average number of shares traded daily.
A blue-chip stock — which is very liquid — will have a small gap between the “bid” and “ask” price at any given time during trading hours. Conversely, an illiquid stock will have a much larger gap between the “bid” and “ask” price.
Also, consider a real estate investment. While you can make tens of thousands of dollars from investing in a great piece of property, you can’t liquidate that investment immediately. You have put your property on the market and patiently wait for a buyer. Real estate is not a liquid investment, but its potential return can be enormous.
Therefore, liquidity is something that needs to be factored into your investment plans. If you want bigger returns, then you need to invest money that you will not need right away.
Risk
While it is our wish to enjoy high returns with little or no risk, it is virtually impossible. While liquidity and returns are inversely proportional, risk and reward are directly proportional. In order words, higher rewards come with higher risks.
When you are considering the risks of investing, your primary focus needs to be on your risk tolerance — not necessary on what “professionals” believe is proper. The fact is that most professionals would tell you the same thing. Remember that most investment articles and information we read is tailored for a general audience.
I cannot stress enough how vital it is for you to know your risk tolerance level. If you make an investment that scares the daylights out of you, then it is not worth the risk. Why? Because as your emotions grow, you are more likely to make a terrible decision — like selling your position on a bad day and then watching it go through the roof the next day.
There is no shame in having a low-risk tolerance. On the contrary, it is smart to acknowledge your aversion to risk — it increases your chances of success dramatically. Most people who lose big in the financial markets have made too many emotional decisions.
The very best way to keep your risk aversion at bay — regardless of personal risk tolerance level — is to set aside funds that you do not need.
Never use money that is an integral part of your family budget, and never borrow money for investing. You will be too emotionally attached to these funds and will make desperate investment decisions.
Diversification
Another important factor in your investment decisions is diversification. This is where you spread investment capital across different financial assets.
Let’s consider an investment in stocks. When you invest solely in one stock, and that stock loses 50% of its value, then your entire investment account has also lost 50%. However, if you invest in two stocks, and one of them loses 50%, and the other gains 50%, then you still have all of your money.
Therefore, diversification is a way of protecting your investment account. The more you diversify, the lower your overall risk and return. Remember that risk and return are directly proportional to each other.
If you like the idea of having diversification — and you should, then your only choice will be how much diversification fits both your investment objective and your risk tolerance level.
This is why financial instruments like mutual funds and index funds have become so popular and desirable. They invest in lots of different stocks, so if one stock goes down the tubes, your investment suffers very little damage.
Another great reason to consider investing in funds is that each of them has an overall objective. Some funds are more aggressive in terms of risk and reward, while others are more conservative. Yet as compared to investing in individual stocks, even the most aggressive funds carry a lot less risk.
