How to Avoid a Bad Investment
How to avoid a bad investment?
How do you decide whether an investment is good or bad ?
Whenever you are investing your money, this question might cross your mind.
Is this a good deal or not?
That's a fair question.
I was reading this book 'The Rich Woman', written by Kim Kiyosaki.
I consider Kim as one of my mentors.
Although this book was targeted towards women, I decided to pick up this book and read it, because I wanted to understand how women think about the subject of money, just to get a different perspective.
So I made sure I read that book completely, cover to cover.
One of the most important lessons I learned from that book is: Kim says, 'Never invest in things that you do not understand.'
It's a very simple statement.
But she lays very much emphasis on this statement in this book, because in reality, a lot of people are investing in things that they do not understand.
If I am investing in things that I do not understand, it doesn't matter whether it's a good investment, or not a good investment.
In my view, it is a bad investment, because it was done with the intention of making quick money.
It was not done after doing proper due diligence.
So the question is this?
How do we invest in things that we do understand, so that we stay away from things that we do not understand?
I look for three things when I am making any investment.
First, I look for the ROI, the return on investment.
The second thing I look for, is the reward to risk.
And the third thing I look for is, how much control do I have on this investment.
Let's take the example of a stock that I want to buy from the stock market.
Is this a good investment? Or is this a bad investment?
Let's look at the first factor, the ROI.
We know that the dividends we receive on stocks are very small, percentage wise.
So my ROI on stocks is going to be very low.
That's one negative point for stocks.
Second, what's the reward to risk?
When I am investing in the stock, as an outside investor, I don't have any influence on the price or the value of that stock.
In fact, I am at the mercy of the stock market to give me the returns.
So it is going to be very risky.
That's another negative point for a stock.
Coming to the third point, which is 'degree of control'.
This is even worse, because when I buy a stock, I don't have any influence on the price or value of that stock, because I don't have any influence on the decisions that the management takes about the business.
That's another negative point for a stock.
So, if a stock investment has got three negative points, why would I ever invest in the stock market?
The only reason why I would be interested is, if I have done proper due diligence.
If I understand the business behind the stock, my way of looking at ROI is going to be very different.
I am not going to simply look at the dividend.
I am going to look at the stock as a business and take a long term view as to how much cashflow this business can provide me, relative to the amount of investment that I am doing right now.
Second, as far as reward to risk is concerned, the more I understand the business, the lesser is the risk that I am taking.
And the more I understand the opportunity, the more is the upside.
So now, I am an active investor in the stock.
The more I know about what I am investing in, the more I am avoiding a bad investment.
Talking about the third point, which is the degree of control, agreed, stocks do not offer me a degree of control.
However, whenever I am making a stock investment, and I am becoming a minority shareholder, I am choosing to lose degree of control, because my research tells me that this business is likely to do well in the future.
So, it's not that I am making a random decision.
I am not speculating.
I am not gambling here.
And after I make the investment, even if the value of the stock falls, that doesn't mean, I made a bad investment.
A bad investment is that investment, which I am making in things that I do not understand.
A good investment is an investment that I am making in things that I do understand.
If the value of those investments go down, I take full responsibility of that, because I did the due diligence, that was required for me to make that investment.
Even the richest people in the world like Warren Buffett, have never made decisions that were all correct.
Even he has lost money on a lot of businesses.
Coming back to Kim's argument that, we must only invest in those things that we understand.
We must stay away from things that we do not understand.
She further goes on to make another argument that, if you want to truly understand something, she suggests that we put a little money at stake.
So take, for example, an investment in silver.
She says that, if I want to invest in silver, and I don't understand silver, then I must go out and buy one ounce of silver coin.
Now when I do that, my knowledge about silver suddenly starts to increase.
Because now, I have money at stake.
I have made some investment in silver.
And I am curious as to why the price of silver keeps going up and down.
So I am going to look around and try to get as much education about silver as possible, just to reassure myself, that I have made a good investment.
Or for that matter, I would like to know whether I have made a bad investment or not.
The important thing to understand here is that, the money that I have put on stake is not a lot.
It is the money that I am willing to lose.
So the basic point that I wanted to convey and emphasise in this post is: never ever invest in things that you do not understand.
No matter how compelling it is, you should be able to describe that investment in one paragraph to yourself as to why you are making that investment.
And you should be completely aware about how the scenarios are going to play out when you make a particular investment.
Talking about investments, we need to get the context right.
And the context is this: The very purpose of an investment is to reach a level where we are financially independent.
The very purpose of an investment is to help us generate enough passive income in our life that can take care of our monthly expenses.
That by the way, is nothing but the definition of financial freedom.
Rohit Musale, CFA
17 December 2022