If you are looking into investing or evaluating your current investment portfolio, the lingo used can be confusing to inexperienced investors. Terms such as net present value, short or long, risk to award ratio, ROI and internal rate of return might make your head spin but in simpler terms they are all tools used to evaluate investments and in sales pitch.
If looking to invest in real estate, a realtor might say to you “It’s impossible to get such a high ROI in this market!”, while the truth is, the realtor is after a commission and you might be astounded to get a negative return on investment after factoring in all the elements.
What kind of investor are you?
Prior to evaluating investments, you have to define the type of investor you are. You will then be in a good spot when evaluating investments. Basically, there are 4 types of investors: fundamental, technical, long term and short term. Fundamental investing relies heavily on thorough analysis of financial statements, the health of a company or business, management, markets and competitive advantages. Technical investing depends on analyzing historical price and volume to determine price direction. Mostly, fundamental will be long term investors and technical short term investors.
How to evaluate investments
Common methods used to evaluate investments are present value and future income. Present value represents what an investment is worth currently and future income is a prediction of what an investment will be worth in future. Most inexperienced investors tend to rely heavily on future income in hopes of prices going up and this at times leads to loss.
If you are a technical or short term investor, go for what is moving the markets right now; and for long term and fundamental investors, the best option is future prices.
Evaluating risks
Before getting into any investment, make sure you clearly understand the risks involved. This is where risk to award ratio comes into play. Even if the risks are low and the awards high, you must be in a good financial position to survive if things go bad. Simply put, do not invest all your life savings and kids’ college money because you have a hunch a stock will go up.
Evaluating regulation and liquidity
Most investments are profitable in solid form, an example is real estate. You should know that liquidating some investments involves significant amounts of fees and taxes. Regulation should also be factored in especially if things go wrong or if an investment has high liability. These can be covered by proper asset management, diversification and insurance.
Evaluating return on investment
For experienced investors, an investment has to make a profit when it’s bought not when it’s sold. If investing in stocks, you need to look at the dividends a stock is paying and the time it will take to recover the capital.
Example:
If you purchase 10000 stocks of XYZ Company at $50 per share, you will have spent $500,000. If the stock pays a dividend of $5 per share twice annually, you will be making $100,000 annually as opposed to buying a stock that pays no dividends and waiting for its price to go up and sell. The latter is commonly referred to as “investing on a crystal ball”.
As with businesses, about half of investments will fail but it’s what an investor does after failure that makes him a success or failure. The B & I quadrants are areas filled with money as well as disappointments. As an investor you must clearly understand the difference between risky investments, risky investing and risky investors.
Sources and recommended reading:
Cash Flow Quadrant (paperback) – Robert T. Kiyosaki
Guide to Investing (paperback) – Robert T. Kiyosaki
Liberman and Lavine (website) – How to evaluate an investment