Investments by means of mutual funds, stocks, bonds, etc. stand for depositing money with prospectively higher returns compared against those attainable in current or savings accounts. Of course, there are more reasons why people start investing. The primary objective of financial investments should be an increase of the nominal value of savings, i.e. returns exceeding the inflation.
Every investment is associated with certain risk. The following picture shows the “magic triangle”, describing the relations among return, risk and liquidity of invested funds.
Uninformed starting investors tend to expect their investments to generate highest returns at lowest risk with readily available money. However, reality is different.
Types of risk Investment instruments are associated with various risks. The most often are:
- Credit risk of incurring loss due to issuer's default, failing to fulfil his obligations according to contract terms (such as upon insolvency of the company).
- Market risk of incurring loss due to changing market prices of investment instruments (adverse development of interest rates, stock prices, commodities or exchange rates). This is one of the most important risks for investors.
- Liquidity risk of incurring loss due to small liquidity of the financial instrument market preventing the sale at market price, which restricts access to funds (liquidation requires time).
- Operational risk arising out of system or human failures (errors in realization of operations, fraudulent operations, unauthorized trading by individual traders,...)
TIP! The best way to mitigate risk is a suitably diversified portfolio.
By diversification, we mean spreading the portfolio to multiple investment instruments. Suitable diversification is of the essence for long-term sustainable success. In a too narrow portfolio, one failed investment may frustrate all plans. A rule applies: the wider the diversification, the smaller the losses from one failed investments are.
Different assets respond differently to changing external conditions. Prices of certain assets may rise while prices of other fall. Thus, loss incurred from one asset can be compensated by gains generated by another.
If the investor is a starting investor who does not have any experience with these products yet, a couple of important questions must be answered. The most important are:
- For how long do I want to invest the money? The answer to this question will be fundamental when deciding on the particular investment instrument to have the investment generate returns as required.
- What loss am I willing to accept? High returns cannot be attained without risk. The higher risk the investor is willing to take, the higher returns he can expect.
- The Investor's questionnaire is a set of questions that assist in determining the most suitable investment strategy for the particular investor.
There is not one universal strategy that fits all investors. However, if following the results of the investor's questionnaire when choosing one's investments in line with the specific indicators (investment horizon, volatility) matching the investor's requirements, the investment should generate satisfactory results. Never put all your eggs in one basket!
Putting all eggs in one basket
This is perhaps the most frequent mistake made by investors when investing all the available funds in one stock title or fund without searching for a suitable portfolio blend. Or, such an investor buys multiple positions in the same asset class (for example, puts everything into commodities). Thus, it is necessary to diversify by titles as well as by asset class.
Unclear expectations of returns
Before making an investment, the investor fails to set the expected return he or she would like to achieve. Consequently, the investor makes purchases and redemptions without complying with the tax test. In such a case, the investor may realize profit, but these investments are rather "Russian roulette" in the long run.
With a view of maximum returns and influenced by the media, inexperienced investors make investments in emerging markets in order to attain high profits over a short period of time. They do not realize that in addition to the risk of frustrated investment, they assume currency risk associated with investments made in a currency other the CZK reference currency. It holds that inexperienced investors should invest in investments having CZK as the reference currency.
Realization of investments at maximum values
Particularly starting investors tend to realize acquisitions at rapid growth values, following the principle: "Look how much does it earn, I'll buy it too". However, every investor should aim at making acquisitions at bottom-low levels and selling at peak levels of an investment.