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#showmethemoney...

Sunday, July 05, 2020

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Not so fast! What's required first and foremost is a sound understanding of how financial ventures work as this affords better and smarter decisions in obtaining your financial objectives.

Take note of the following core concepts which will indicate if you're headed down the right path to realising your money goals, which in today's world must ultimately be the building of wealth in a sustainable way and not simply here today, gone tomorrow.

 

Risk vs Reward

Generally speaking, the greater the risk an investor takes, the greater her reward should be. That is, of course, if your investment makes money. Let us say she wants to invest in stocks. Investing in an established company, while it is probably a safe investment, will likely not yield very high returns simply because there isn't much risk there. Say, on the other hand, she decides to invest in a new hot-shot company in, for argument's sake, medical devices, that's poised to do big things in that field with a new invention it's come up with. Because it doesn't necessarily have that much of a track record, investing in it is a huge risk. Then, let us suppose, something happens within months of purchasing the stock — a scandal is uncovered that reveals their invention does more harm than good — that sees the company going out of business. That investor would lose the entire value of her investment. But the inverse is true, too: the company's stocks could skyrocket, making a lot of money in a few months. Here is where the investor would trade her risk for great reward, becoming wealthier off a small investment. There is a point where the risk/return diminishes, where taking on a lower return and a higher return involves the same risk. Ideally, one needs to balance their portfolio to achieve the highest return for the lowest risk. I have seen many burnt by running solely after that “hot shot” stock.

 

Cash Flow

Have you ever looked at your bank statement in utter shock at how much money you've spent in one month? This personal cash flow statement is really an indicator of what you spend vis-à-vis what you earn, and provides a small glimpse into your financial healthy. The aim is for your cash flow to be positive; in other words, managing your cash so that you are not drawn into bad debt. A rule of thumb for obtaining positive cash flow so that you can sooner reach your financial goals — whether building an emergency fund, paying down debt, saving for retirement or even investing — in a timelier manner is this: Spend less than you earn, also known as living within your means. After all, you should be sceptical about investing in a company with negative cash flows. Run your personal finances like a well-run business.

 

Time Value of Money

The operating principle here is that a dollar today will always be worth more than the exact amount tomorrow because of money's potential to grow by way of compound interest today as against some time in the future. Say, our investor wins a sweepstakes prize like what we see on TV. She has the option of taking the lump sum all at one time or she can choose to take an agreed-on amount every month for a year. The savvy and responsible investor will choose, once she knows she has no plans to fritter away the money, to put it invest and allow the interest to accrue, as against waiting each month for roughly 28 days, during which time the money is bearing no interest whatsoever. The objective would be to e earn more on the lump sum than if she'd lodged it piecemeal over the course of a year.

 

Diversification

If you want your exposure to your assets to be limited, the process of diversification does just that by spreading your investments around, over several asset classes, thus reducing the volatility and mitigating the risk in your portfolio over time. The optimal way to diversify is to pick investments with different rates of return and varying risks, including stocks, bonds, short-term investments, and funds, among others. This principle is the embodiment of the saying, “Don't put your eggs in one basket.” Diversification is the financial solution or strategy that acts somewhat as insurance against big losses and wholesale financial ruin. So in summary diversify industry, currency, asset class, risk and tenure.

Profitability & Liquidity

Liquidity is generally defined as how easily assets can be converted into cash, which is the most liquid of all assets. Stocks and bonds are not always very liquid but T-bills and repos are considered to be liquid because they can be converted into cash in a matter of days, if needs be. They are called liquid assets. But whilst the investor needs to be clear on the marketability or the liquidity of her investment, she, on the other hand, needs to balance that concern with investing in such a way as to ensure the maximisation of profit (long term), which she will not realise if the investment can be quickly and easily sold off (short term).

 

Hedging

Hedging is really risk-management techniques to offset the risk of adverse price movements. It's sort of like buying insurance for your home to protect against events like fire, burglary, and so on. But hedging, whether as it regards stocks or ETF (exchange traded funds) investing, is slightly more complicated. Hedging reduces exposure to various risks using one investment to hedge the risk of another, that is they have an inverse relationshipAnother hedging tool is to employ the use of put and call options. Say, you want to protect yourself from a fall in the value of a stock you areunsureof, you can buy a put option that allows you to sell shares of that stock at a strike price in the future. If the price of the stock tumbles you offset your stock losses with gains from the put. There are other options at an investor's disposal, including calls, futures contracts, commodities, even interest rates.

Become financially literate in these basics so that you don't blindly follow trends and arrangements that are often attractively packaged and promise untold wealth without presenting the larger picture that risks may be involved.


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