Finding the right kind of investment is an important factor in generating passive income and have your money working hard for you. There are a lot of things you can invest in, this includes GIC, bonds, stocks, options, tax liens, real estates, and businesses. Each of these investments have their own intrinsic risk. Some of these investments are considered more conservative, while some are considered more risky. How do you tell which investment is conservative and which one is more risky? Well, the general rule is that the higher the return, the higher the risk. For example, over the long run, stocks typically have higher returns than GIC’s. However, investors who invest in stocks will have to face the fact that stocks also have higher risk than GIC's. There's simply no free lunch when it comes to investment.
Since there's always a risk when it comes to investment, before plunging yourself into an investment opportunity, you need to sit down and ask yourself these 3 key questions:
- What is the upside of this investment opportunity?
It's easy to consider the upside of any investment opportunity. Simply put, the investment will make you money. The question is how much is the upside. Are you expecting to get 10% return in 1 year? 50% return in 1 year? Or 500% return in one year? It's human nature to get very excited to hear about the upside potentials. Spending time thinking about the upside of an investment opportunity will also allow you to evaluate how risky the investment is. If an investment opportunity can return 500% in one year, chances are it will be very volatile as well. Would you be comfortable with the volatility? It's easy to say that you won't get affected by the volatility when you're on the sideline looking in. When you're standing neck deep in water, the world sure looks a lot different. Would you lose sleep over the volatility? How would your quality of life be affected?
- What is the downside of this investment opportunity?
On the other hand, some people are so concerned about the downside of an investment opportunity that they completely miss the opportunity. These people are so concerned about the day to day investment value, that they failed to see the big picture. Rome wasn't built in one day and your investment portfolio certainly won't either. Some people are so focused on the possible short term downside, they fail to realize long term potentials. Instead, they decided to play it safe and put all their money into conservative investments like GIC's, which pays less than inflation right now. Over time, although the portfolio dollar amount is increasing, they are actually losing purchasing power! Just like spending time to consider the first question, spending time thinking about the downside of an investment opportunity also allows you to reflect whether this opportunity is right for you. Are you OK with the potential downside while knowing the potential upside?
- Can I live with the downside?
While the first 2 questions are very important, I have to argue that the most important question to ask yourself is the last one - can you live with the downside of the investment? What if you lose 50% of your investment portfolio? What about 80%? What about 100%? Can you continue to sleep well at night? Can you continue to live your desired quality of life? Or are you going to be so upset about this devastating event that you end up doing the unthinkable? We rarely think about the downside before investing and this is one of the biggest mistake we can make. You need to be able to have conflicting thoughts about an investing opportunity.
How do these 3 questions apply to me when it comes to investing? I won't lie, I certainly am guilty of making investment decisions without thinking about these 3 very important questions. I have lost some money because I was too focused on the potential upside but I have also missed some great investment opportunities because I was too scared about the potential downside. I was too worried about that 1% dip in my investment portfolio that I failed to see the potential 10% upswing.
Take our dividend portfolio as an example. Both my wife and I are not comfortable about the downside of buying stocks on margin, so we do not use margin. We only invest with money that we have. Furthermore, the money invested in dividend stocks are money that we do not need for the foreseeable future, so in some way we are OK if the value of our dividend portfolio decreases by 50% or more. We can live with the potential downside and we can continue adding capital into the dividend portfolio to purchase addition positions. On the other hand, we are also OK with the potential upside of the dividend portfolio because we understand the companies that we invest in will continue to grow, which means the dividend portfolio will increase in value over time as well.
As investors, we all must be ready to argue both sides on why we should and why we shouldn't invest in an opportunity before taking the plunge. As Warren Buffet said before - “Optimism is the enemy of the rational investor.” Start asking yourself these 3 questions whenever you’re faced with an investing opportunity.