There are lots of different ways to make money by investing. Unfortunately, not all of them have a good chance of working out as planned. In this article we highlight the characteristics shared by many of the best investments. Using this list of traits as a checklist will help put the odds in your favor by avoiding investments with a high chance of failure.
- Why should you invest?
- What is a good investment opportunity?
- Characteristics of a good investment
- Can you turn bad investments into good ones?
Why should you invest?
Investing, which comes in many shapes and forms, is a way for us to lend money to the economy, and then share in the growth of the economy. Investment is required to generate wealth, and investors get to share in that wealth creation. Investors are also rewarded for taking on risk.
Investing is the most reliable way to reach your financial goals and become financially independent. Very few people will earn enough in their lifetime to retire by simply saving. Money that is simply saved will not keep pace with inflation, let alone grow. For this reason, most people need to take on a moderate amount of risk via a diversified portfolio of investments.
What is a good investment opportunity?
The difference between a good investment opportunity and a bad one comes down to the probability of success and the level of risk. There is a big difference between probability and possibility. Just because it is possible that something may occur, does not make it likely to occur. Buying investments based on their value possibly appreciating is speculating, regardless of the potential return. Good investment ideas have a high probability of success.
The level of risk for an investment should also be low. Periodic losses and volatility are a part of investing. With a good investment there should be very little chance of losing the total amount invested. Good investment ideas will hold their value or increase in value for a long time. This will allow you to exit at a good price. Short term investments should have a high level of safety and liquidity.
8 Characteristics of a good investment
The following are some of the traits of good investments. An investment does not need to have all these traits, but there should be an acceptable reason for the absence of any one of them. For example, an investment does not need to provide income, if it is expected to grow in value. If it does neither, there is no point owning it.
1. Fairly valued
If you overpay for an investment, you are putting yourself at a disadvantage. Good investments are usually bought at a good price. With equity investing, valuation relative to future growth is key. Market timing may have its limits, but stock valuation plays a big part in determining future returns. Buying at a fair price is not necessarily the same as value investing, but the price should always be reasonable and based on reasonable growth assumptions.
The same applies to other asset classes too. Real estate investments should be based on yield and not just on the assumption that the price will increase. Cyclical assets like commodities should be purchased after a down cycle when fundamentals begin to improve.
The field of behavioral finance has shown that investors are often motivated by biases. Rather than getting caught up by market sentiment, investors should use extremes as an opportunity to buy and sell at attractive prices. There may be occasions when you can justify paying a premium because you have reason to believe the premium will expand. However, you should know whether you are investing vs. speculating. If you are speculating, risk needs to be managed carefully.
2. Underlying value will increase over time
The best investments are more often than not assets that increase in value over the long term. Whether it’s a company or real estate, this occurs when the asset owns or produces something that is in demand. Company values increase when they reinvest profits to increase capacity. Property values increase because real estate is limited while demand is not. While the stock market as whole has increased in value, the same is not true for all companies.
Contrary to some popular investing myths, this doesn’t mean you should only buy blue chip stocks or those of well-known companies. Any company that can grow market share within a growing market can be a good investment – provided you buy it at the right price. On the other hand, some blue-chip companies are in industries in terminal decline.
ETF investing using broad market index funds will keep you invested in the companies that see their value’s increase. The returns may only be in line with the market, but your exposure to overhyped companies and industries will be limited. Quantitative investing research has shown that stocks that outperform share certain characteristics, known as investment factors. Factor investing is one way of picking stocks with better odds of generating good returns.
Many industries are undergoing a period of change due to social pressure. Environmental, social and governance issues are becoming increasingly important to long term value creation. ESG investing factors are therefore becoming just as important as growth and profit margins for stock picking.
It’s not only stocks that can accrue value over time. Compound interest enables bonds and real estate investments to grow in value too. The value of commodities is a little bit more difficult to assess. Demand for commodities does rise, and supply is to an extent finite. However, the price of a commodity typically accounts for future demand. Commodities are more likely to rise in price when supply has fallen, and demand is beginning to increase.
3. It is diversified
Diversification is a key element of successful investment portfolios. To diversify when buying stocks, bonds and other assets you need to build a portfolio of securities. When it comes to products like mutual funds or exchange traded funds (ETFs), the products themselves offer various levels of diversification.
Funds that are spread across several sectors will offer better diversification over the long run. Investors are often tempted to invest in funds that concentrate on industries or sectors that are performing well at the time. These funds may not perform well when investors move on to other sectors.
4. It diversifies your portfolio or reduces portfolio risk
Any investment you add to your portfolio should be a good investment in its own right, but should also add diversification to the portfolio. For example, if you own an ETF that tracks the S&P 500, there is little point buying another fund that tracks a similar index. A fund tracking a European index, or a global index would offer more diversification. Asset allocation ensures that a portfolio can weather any storm.
Adding instruments and funds from asset classes with a low correlation to equities also helps to reduce portfolio risk and volatility. Various methods of portfolio hedging can ensure your investments are not too closely correlated to equity markets. This will preserve value during a bear market or a stock market crash.
Hedge funds exist for exactly this reason. Hedge funds can use leverage and short selling to capitalize on short term opportunities and negative price movements. Catana Capital’s Data Intelligence Fund utilizes an innovative investment strategy that is able to generate returns that have a low correlation with equity markets. This is achieved by using artificial intelligence to analyze unique big data sets in real time. The fund assesses market sentiment for each stock from user generated data which updates in real time.
Small private investments can also diversify a portfolio. Owning a rental property, an income producing website, or a small business can all lower the volatility of your overall investment portfolio.
5. It is liquid
Different types of investments have varying levels of liquidity. Large cap stocks and ETFs can be sold very quickly. Some funds, like hedge funds can only be redeemed monthly or quarterly. Real estate and investments in small businesses are even less liquid.
There are several advantages to illiquid investments. Most investments that are not listed on an exchange do not have real time, or even daily pricing and so their values are less volatile. Illiquid investments can also prevent you from making impulsive decisions. In aggregate your portfolio should have a good level of liquidity. Whenever you consider a new investment you should consider whether it will make your entire portfolio more or less liquid.
6. It generates income
If an investment is not expected to grow in value, it should generate a yield. Many of the best long-term investments turn out to be those that have a steady, continuous yield. This can come in the form of stock dividends, bond coupons or rental income from properties.
Not only does a yield give you a passive income, but the ability of an investment to generate cash proves it is profitable. There is often a danger that growth investments can be speculative. Investment products, companies and properties that can generate cash are less likely to be speculative investments.
However, an investment with a yield will only make a good long-term investment if the cash flow is sustainable. It often pays to focus on sustainable cash flows rather than chasing the highest interest rate or yield.
7. You understand the product and the risks?
A good investment for an experienced hedge fund manager may not be a good investment for the average retail investor. If you cannot understand how an investment will grow, or create value or generate profits, it should be avoided. This goes for companies, funds or any other structure.
Complexity is often used to mask a flaw in the business model. This applies particularly to complex trading and investments strategies and to derivatives. Risks comes with any investment, but if you do not understand what you are investing in, you won’t know how much risk you are really taking. The following are some of the types of investments that are best avoided unless you really know what you are doing:
- Multilevel marketing or investment schemes
- Derivatives – in particular binary options
- Any product with leverage of over 3x
- Leveraged and inverse ETFs
- Trading strategies with a low win rate / high return profile
- Small cap stocks that are not yet profitable
- Any private investment that you do not have personal knowledge of
Cryptocurrencies and forex trading are best regarded as speculative too.
8. It is regulated or protected
The way any investment product is structured and regulated should offer investors protection. This applies to companies, investment products, intermediaries and strategies. How your investments will be protected against fraud, insolvencies and other potential risks must be considered when weighing up investment options. Companies listed on major exchanges are subject to oversights that offers shareholders a certain amount of protection. Unlisted companies and those traded on OTC markets are not subject to the same oversight.
Investments domiciled in a country that takes regulation and governance seriously is more likely to offer you some level of protection. In many jurisdictions, accounts held by regulated brokers are insured. If an unregulated broker becomes insolvent, investors may lose their investments.
The same applies to intermediaries like a financial advisor or fund manager that should be properly regulated. In this regard there is an advantage to investing via a asset management firm or robo advisor. These firms face reputational risk if they do not ensure all their investments are properly vetted. Not all asset classes and investments can be regulated to this extent. In this case it’s important to do as much due diligence as possible to make sure you understand the risks.
Can you turn bad investments into good ones?
The reality of investing is that some investments won’t work out as planned. Very often the best thing you can do, is to exit the investment and move the capital to a better investment. Emotionally this can often be difficult, causing people to “throw good money after bad.”
To get past this hurdle, consider the amount you can recover and then ask yourself whether it would be worth reinvesting it back into the same investment. If the answer is no, it’s probably time to exit. Occasionally there may be a way you can turn the investment into a good one. This is more likely to be the case with private investments.
In the case of a fund or instrument, you will need to decide whether the investment is performing poorly because of market sentiment, or because it’s just a bad investment. If market sentiment is the problem, it may be worth being patient. If the underlying investment is weak it may be better to exit.
The best ways to invest money successfully is to avoid the wrong types of investments. Often investment ideas that look attractive at first glance end up losing money. If you look for the eight traits of good investments listed above, you can avoid many of the investments that go on to disappoint. As mentioned, not every investment needs to have every characteristic, but there should be a good reason if it doesn’t.