Want to start investing, but do not know where and how to? Follow my step to step guide on investing and trading.
– Drawing your financial roadmap
– Determining your investment goal and length
– What are risk and return
– Determining your capital budget
Why Are You Investing?
Determining your purpose for investing is extremely important because it maps out which investment vehicles you should use and how much money you will need.
Most common purposes for investing are
Making a large purchase in the future such as a diamond ring or refurbishment
Starting a Business
The first thing to do is to draw a financial roadmap, write down clearly “why” are you investing and how long are you planning to invest. Are you investing so you could pay for a down payment in 10 years or a car in 5 years? What is it?
Once you have your “why” and investment length, you need to understand the relationship between risk and return. Risk is a quantitative probability of something wrong that is going to happen, such as losing all your money in an investment.
Risk and Return
So How Do Risk and Return Correlate?
Risk has a direct relationship to return. Higher risk means a higher return. Take cash, for example, it is a liquid, and you are not afraid to lose it because it is low risk. But, what does low risk mean? There is no return. You are losing money for holding cash due to inflation. When we are observing returns of investment, we should look at real returns instead of nominal return. Real return is nominal return deducted by inflation and tax rate.
There are two types of risk when investing: specific risk and systematic risk. Specific risk is the risk of failure of a particular asset, and systematic risk is the macro risk of the entire market. The Financial Crisis in 2008 is an example of systematic failure. Essentially, we can eliminate and control the amount of risk taken by diversifying our investments, which means not to put all your eggs in one basket.
Everything you do in life involves risk. When you drive into the gas station, what is the probability of a gas leakage that can cause an explosion? When you are travelling, what are the risks flying? Our brain is more sensitive to the bad things that can happen to us because of our Fight or Flight response. Our first instinct in investing is what could happen if all the money is lost. As a result of our natural fear instinct, many people are afraid to invest. Being more educated in personal finance, not only gives you confidence in investing but also it can help you generate passive income.
How much are you planning to invest? How much money do you need for your investment goal? If you need USD 100,000 to attain your investment goal, how much do you need to put in today assuming you earn a 7% return? The most important question of determining your budget is: if you are going to lose 50% or 100% of your investment, how could that impact your lifestyle? Would you be able to live in the same quality of life?
If your answer to these two questions is yes, then your budget amount is adequate. If not, then your capital budget is too much. A standard benchmark is that your total cash should be 5-10 times of your portfolio value. If you plan to invest USD 100,000, you should have at least USD 500,000 cash in your bank. These are all the questions you have to answer your financial roadmap.
Now that we have an understanding of how risk plays a role in investing, we need to determine your capital budget. What is capital budgeting? It is how much you are planning to invest.
For those who are ready to invest and do not know what your budget should be, I have created a tool, absolutely free, to determine your capital budget. In the calculator, you will be asked to input your investment length, goal, and expected rate of return. If you are unsure of the expected rate of return, use the default rate.
Type of Investment
You may be familiar with investment vehicles such as real estate, stocks, bonds, and mutual funds. But, there are a lot more in the market, such as: