Saturday, October 21, 2006

Principle #20 - Investments Must Be Understood

When investing it is important to understand why you are parting with your hard earned cash. Understanding an investment can and should be done from several different perspectives.

What makes the investment attractive? This is fundamental. If you do not understand why you are buying an investment then you should not be buying it. If you cannot articulate in a few short sentences why you are buying something, then you are not investing - you are gambling. In evaluating an investment, both the potential return and the risks need to be considered. The reasons for buying should be both clearly understood and should be sound reasons. My benchmark test for having a sound reason for investing is a simple one. Before making the investment I ask myself if, should the investment lose money, I could explain to Mrs Traineeinvestor how I had lost some of my hard earned savings without sounding either reckless or stupid.

Individual investments do not exist in isolation. They are part of a portfolio and part of an overall financial plan. If an investment, however attractive, does not fit with the portfolio or the plan, ask whether it is an appropriate investment. There are plenty of other investment opportunities out there. If you find a compelling investment which does not fit with your financial plan, it may be worth revising the plan before proceeding.

Lastly, an investment will be made on the basis of an expected return and identified risks. It follows that you should understand when or in what circumstances you should be liquidating the investment (either for a gain or a loss) before you make the investment.

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