1. Why to invest:
Investments are not necessarily less risky than holding cash. In fact, over the long term, holding onto cash is considerably more risky than investing. Inflation is widely accepted as necessary for economic growth in modern society. The Federal Reserve regularly sets an inflation target of about 2% per year. This means that if everything goes according to plan in our economy, today’s dollar will be worth about $0.98 next year. Investments are not limited to speculative bets that “grow your money” but they also hedge your savings against inflation risk.
2. What to invest in:
The most popular asset classes in the modern financial system are stocks (mutual funds are usually also stocks), bonds, and real property. Each of the three major asset classes presents opportunities and drawbacks.
- Stocks represent a share of ownership in a company, and a claim on that company’s profits.
- Bonds represent a financial obligation by a debtor to pay the bondholder.
- Real property represents the ability to make use of land.
Historically, stocks have outperformed bonds and real estate on the macro-level. Returns are closely related to interest rates. Low interest rate environments favor investments in stocks and real estate, while high interest rate environments favor investments in bonds.
3. What else to invest in:
New financial instruments have made it possible to invest in a wider variety of asset classes. It is, for instance, now possible to buy and hold precious metals using exchange traded funds.
Those with specialized knowledge often find they are able to generate significant returns by investing in tangible assets. Numismatics (coin collecting) is a good example of this. Sometimes, however, these tangible investments can lose their value very quickly if it turns out a particular group of tangible assets was a fad. Remember beanie babies?
Another often overlooked place to invest is in yourself! The return on investment for acquiring new skills and increasing your earning potential is often much higher than anything that can be found in the market.
Those were the basics. Now for some principles that can aid you in achieving strong investment returns over the long-term.
If investing had a cardinal rule, this would be it. Don’t put all of your eggs in one basket. Diversification means spreading your investments not only among different instruments within a single asset class, but also between different asset classes. Keep in mind that diversification reduces both upside and downside risk. However, in the long term, reducing downside risk is perhaps more important when securing your future income. If you disagree, what you may actually be interested in is gambling. Gambling is lots of fun, but generally makes for a bad investment strategy.
5. Manage your liquidity.
Liquidity risk is the risk that one day an investment opportunity or catastrophic personal expense will arise, but you will be unable to sell your assets for a fair price within the necessary time-frame in order to effectively manage it. Make sure to keep some percentage of your portfolio in cash or other highly liquid instruments in order to mitigate this risk.
6. Consider the greater fool, and wonder if it’s you.
Sometimes you will know that an asset is priced well above its fair value. However, it may be likely that the asset will continue to appreciate far beyond even its current inflated value. Keep in mind that there is a lot of money to be made in riding bubbles, and a lot of money to be lost in riding them too long.
Remember; if you don’t know who the sucker is, it’s probably you.
7. Beware of reflexivity.
Sometimes the world has a funny way of interacting with itself, and sometimes what happens in our imaginary financial world has a way of affecting the reality it is based on. Reflexivity in the financial markets is basically the idea that prices don’t just convey information, they actually change the fundamentals. An example of this might take place as follows: Let’s say there is a technology company worth $2 per share and trading at $2 per share. Due to market hype, the price is driven up to $100 per share. In response to this, the company sells some of the stock that it owns. Now it has quite a lot of cash on hand and it uses that to finance R&D that generates a profitable new product. With the addition of this new product the company is now worth $125 per share.
The example is exaggerated but the principle is that what happens in the financial market not only reflects the underlying reality, but also affects it.
8. Take nothing for granted; and be cognizant of the possibility of meeting … the “black swan!”
Black swan events are random and unpredictable events that are beyond the realm of normal expectations. Notice that I didn’t say to be “prepared” for them. It is hard to prepare for black swan events because by definition they are unpredictable. But cognizance of such events will lead you to be a more skeptical and better informed investor. Be aware that we are quite limited in our perceptions of reality, and we only have data on what has happened in the past. Therefore, any model of reality that we have assumes conditions similar to the past. We have ZERO guarantees that such conditions will prevail. There is a probability that such conditions will prevail, but we don’t actually know what that is.
That said, not taking the future for granted is a strategy that is useful not only for investing, but for life.
Best of luck.