Don't Invest in Anything Unless You've Answered These 4 Questions First – Motley Fool

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So, you’ve saved up a little cash and you want to invest it.  Good move — investing in assets that can earn you a healthy return is key to achieving financial security. But where exactly should your money go?

There’s an almost endless array of investment options, from stocks and bonds to cryptocurrencies or real estate. Each of the choices open to you has advantages and disadvantages, with the most obvious possible downside being the chance of losing all your money. (And with a few investment options, such as shorting stocks, you can lose even more than you’ve invested.)

You want to make smart, responsible choices as you build your portfolio. Answering these four questions about any potential investment before you put your money into it will help you do just that. 

Dice with buy, sell, hold, sitting on investment paperworks next to a stack of money

Image source: Getty Images.

1. What is the risk level?

There is no such thing as a risk-free investment. Even keeping your money in cold hard cash puts you at risk of loss due to inflation or the value of the dollar declining. 

Since you can’t avoid risk, you’ll need to manage it by making a conscious, personally appropriate choice of how much risk you’re willing to take.

The basic rule of thumb is, riskier investments offer more potential for higher returns. When you’re young, taking reasonable risks — like investing in stocks — makes sense to chase those higher returns. As you get closer to retirement age and will have less time to recover from downturns before you’ll need to start selling, it’s generally wise to shift some — but not all — of your money into safer investments. 

Figuring out your risk tolerance is the first step. Then, evaluate each and every investment to see if it’s appropriate for you. There are technical formulas to gauge risk based on how volatile an investment is in comparison to the stock market as a whole. You should also look at the fundamentals of the investment and, when available, review risk-ratings from services like Moody’s Investors Services, Standard & Poor’s, Fitch, or Morningstar.

The more information you collect, the better you will be able to assess whether the potential returns are worth the risk for you. 

2. How will you earn a return on this investment?

The point of investing is to make money — so before you put your hard-earned cash into anything, know how exactly how that will happen. 

Different investments make money in different ways, and, in some cases, there more than one.  If you buy real estate, you may make money from rental income and property appreciation. If you buy a stock, you’ll make money if the share price rises, but the company may also distribute profits as dividends.

Before investing, understand what must happen and the conditions that must occur — like property values rising significantly — in order for you to earn a return. Consider, as well, the time it could take before those conditions are met — and the odds that they might never be.  

If you’re eying government bonds, the returns of which rely on repayment of debts, there’d be reason to worry about bonds issued by Venezuela, for example, since the political situation there makes that less certain. If it’s likely to take years to earn a profit on your investment, the potential return needs to be greater to justify both tying up the cash and to compensate you for the risk that conditions may change and sap the value of your asset. 

3. What is the cost to invest?

An investment’s costs can take many forms, from commissions to buy or sell it to fees paid for the privilege of holding the asset. Many mutual funds, for example, charge management fees, while real estate notoriously comes with high transaction costs in the form of  realtors’ commissions, transfer taxes, and other closing costs. 

Before jumping into any investment, carefully evaluate all of the expenses associated with buying, selling, and holding it.  The higher the cost, the greater your returns will need to be for your investment to be profitable. 

4. How well do you understand the investment? 

One of Warren Buffett’s best pieces of financial advice is that you should never invest in anything you don’t understand. This could mean foregoing your chance to buy bitcoin if you don’t understanding the intricacies of the cryptocurrency market; avoiding art investing if you can’t tell a Kandinsky from your kids’ art on the fridge; or sticking with ETFs for stock market investing if you can’t read a company’s income statement

When you don’t understand the details of the investment, it’s simply too hard to assess its risk or determine the likelihood of earning respectable returns. In those cases, you’re not an investor — you’re a speculator. That’s not a good thing to be with your hard-earned cash. 

Don’t be a gambler — be an investor

You work too hard for your money to gamble with it by investing in anything before answering these key questions.

The great news is, there are plenty of great resources available to help you learn about different investment opportunities and to teach you how to better assess their risks and measure their potential returns. So, dive in, learn what you need to know, and become the kind of investor who makes your money work for you. 

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