Evaluating an investment is part of the skills and habits of a good investor. Investments can be riskier than they appear, a fact that many investors tend to overlook.
Often, anecdotes and advice from people who have made it big by investing in a particular penny stock, or other type of investment vehicle, can sway our actions and decisions.
Unfortunately, investing isn’t quite as easy as others make it out to be. There are many risks involved, and to ignore these risks is to end up placing your hard-earned money in the wrong hands. This is why knowing about evaluating investments is so critical for investors.
> From our Dictionary: ‘What is Risk Tolerance’.
Steps for Evaluating Investments
Every good investor analyzes and evaluates an investment, but at the same time, it’s impossible to eliminate your risk completely. The only risk-free option is to stick to a savings account, but that stunts the potential for growth, as well. Therefore, it’s key to identify the risk factors in a particular investment you’re eyeing, so you can pick one with significant returns high enough to offset the risk involved. Here are several factors to help you evaluate the risk factor:
1. Look at the Time Horizon
Time is an important factor for evaluating investments that could easily affect the risk calculation for any particular investment. For example, a risky stock investment wouldn’t be so problematic if the investor can let the money sit tight for ten years or more. This increased time horizon allows the investor to ride out the volatile changes to the worth of the stock, thereby minimizing the risk involved.
However, the effect of a long-term investment may vary depending on the asset class involved: for stocks and real estate, longer time horizons are usually optimal. For bonds, however, the risk increases the longer you let the investment sit, due to liquidity.
2. Think About the Wild Side of Volatility
As the name suggests, a volatile investment can swing wildly both ways. It can either earn very high returns, or wipe out your investment entirely. A common method of measuring a particular investment’s volatility is the standard deviation measure. The standard deviation measure looks at the trends for a particular investment, such as the total returns. It also tracks changes over a given period.
> Read more: Is Stock Market Volatility our New Normal?
The higher the standard deviation of an investment, the more volatile it is in the market. When it comes to evaluating investments, this enables you to measure the risk factor involved, which helps you figure out if you would be able to handle the subsequent wild changes in terms of total returns. If a volatile investment isn’t for you, then it’s time to look for something else.
> Other volatility indicators: VIX, VXN, Fear & Greed.
3. Consider Asset Class
Different asset classes have different risks and returns. Stocks can be low, medium, or high risk factor depending on the individual company. Property such as real estate is less volatile but can also suffer from liquidity risk and market volatility.
4. Mix in Some Alternative Assets
Assets, such as venture capital, non-traditional investments and private equity offer high returns, but include high risk, as well. Price volatility can be a problem, too. For alternative assets, experts recommend long-term investment to offset the potential risks.
> Read more: Alternative Investments and Your Portfolio.
5. Keep an Eye on External Shocks
The economy is subject to a number of shocks, such as political upheavals. Apart from these, it’s important to note the potential effects of changes in credit spreads and interest rates. It is difficult to foretell upheavals, but keeping up with news reports and identifying potential problem investments can help an investor avoid too much risk.
6. Balance with Portfolio Diversity
When considering a potentially risky stock you’d like to invest in, it’s crucial to look at the other stocks you already have in your portfolio. This is because risk is almost impossible to avoid completely as far as investments are concerned.
> Read more: Reallocate your portfolio. 3 Warnings!
As such, it’s possible to have a healthy, diverse portfolio with a combination of stocks that are low risk, medium risk and high risk. A diverse portfolio allows for greater returns without entirely compromising your investment. If you already have a number of high risk stocks in your portfolio, start investing in low and medium risk stocks to achieve a better balance.
> Read “Investment Portfolio Basics: It’s All About You,” for even more information on evaluating investments and setting up your investment portfolio.
In conclusion, it is important to remember that risk is inherent in any investment and should be evaluated carefully before making a decision. By following the six simple steps outlined in this article, you can make an informed decision about whether an investment is right for you.
Related with Risk:
- Find your Risk Tolerance and the Type of Investor You are.
- Get to know your investing style with these questions.
- Follow the 5 Habits of successful investors.