By T.J. Porter, WCI Contributor
Investing is one of the most effective ways to build wealth over the long term. You can only work and earn so much, but if you put your money to work for you, its ability to grow will only compound over time. Identifying good investment opportunities, however, can be difficult. These are some of the top characteristics of a good investment.
Reasonable Risk and Reward
All investing is subject to risk, but different types of investments have different levels of risk. For example, buying stocks is generally seen as riskier than buying bonds. A company could fare poorly and see its stock price fall while bonds offer a consistent income as long as the issuing party doesn’t go bankrupt.
Does that mean that bonds are a better investment because they are lower risk? Not necessarily. Because stocks are viewed as riskier, they tend to offer higher potential returns. Identifying a good investment starts with understanding the risk and potential rewards that the investment offers. You need to make sure that risk and reward are evenly balanced.
Consider this example:
Someone gives you the option of paying a dollar to flip a coin and call heads or tails or paying a dollar to roll a six-sided die and try to predict the number that comes up. If you guess the coin flip right, you’ll get $2.01 back. If you guess the die roll right, you’ll get $20 back.
There’s less risk with the coin flip. You only have a 50% chance of getting it wrong and losing your $1. With the die roll, you have a five in six (or 83.33%) chance to lose your dollar. Given you have 50/50 odds of winning the coin flip, you’ll get an average of $1.005 every time you flip the coin. Your 16.67% chance of getting the die roll right means you’ll get $3.334 for every die roll on average.
Even though your risk of losing the $1 with the die roll is much higher than a coin flip, the return on the die roll is significantly increased to compensate for that higher risk. That makes the die roll a potentially better choice.
To return to the example of investing, stocks are riskier than bonds, but they offer higher returns, meaning they can still be a good investment. If something is high-risk but offers similar returns to an investment with low risk, then it isn’t a good investment opportunity.
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An Appropriate Amount of Investing Risk
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Low Cost
Low cost in this sense does not mean that the investment itself is cheap. Expensive investments can still be good investments if their potential returns are reasonable. Low cost refers to the expense of owning the investment.
For example, mutual funds are an easy way to build a diversified portfolio of stocks and bonds. Buy shares in one mutual fund and you get exposure to dozens or hundreds of different securities. However, mutual funds charge a percentage of your invested assets each year as a fee.
The lower this fee, the better. To demand a higher fee, an investment must offer higher potential returns, sufficient to offset the fee. Consider that an investment returning 8% annually with a 0.5% fee will outperform one returning 10% annually with a 3% fee.
Other investments will have different costs. Real estate requires maintenance and repairs. Buying a business means covering payroll, supplies, and other operating expenses. Consider all of the costs (including the value of your time) and whether the returns are sufficient to offset the costs before investing.
Consistency and Volatility
Which would you rather have: a savings account that pays 5% interest every year or one that has a 50% chance of paying 10% interest and a 50% chance of paying no interest? Theoretically, they should both offer roughly the same return, but most people would prefer the consistent option.
Investments can be inconsistent and volatile. The less consistent and more volatile an investment is, the worse the investment tends to be. To compensate for that volatility and inconsistency, the investment must offer higher returns.
For example, an account that has a 50/50 chance of paying 15% interest would likely be worth considering over a consistent 5% because the average 7.5% return is sufficiently higher to compensate for the lack of consistency.
Liquidity
The liquidity of an investment plays a big role in whether it is a good investment opportunity.
Some investments—such as stocks, bonds, or mutual funds—are highly liquid. You can sell them and turn them into cash in days. Others, such as a business or real estate, can take weeks, months, or even years to sell and turn into cash. The transaction costs are also typically higher. As has become the clear theme so far, the way that an investment must compensate for a lack of liquidity is through higher potential returns. If something is harder to offload, it must make it worth the effort by providing higher cash flows or more price appreciation.
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Effort Required
Some investments are very easy to manage. Mutual funds are a popular set-and-forget way to invest. Just put money in the fund and let the manager do the work. Other investments, such as rental homes, require a lot more hands-on work, and the more work you do yourself, the more money you can save in management fees and the higher the returns you can achieve. Investments that require a more active hand aren’t necessarily bad, but they must provide better returns.
Conclusion
So, what are the characteristics of a good investment? It’s simpler than many people would think. Something that has a reasonable balance of risk and effort to reward can be a good opportunity. The more risky something is, the greater the potential return it must offer. What counts as a good investment for one may not meet the needs of another. You also have to consider your risk tolerance and willingness to take an active role in managing the investment.
For some, earning an extra 1% is worth some hands-on work or more volatility. Others prefer to be as hands-off as possible when investing, and they would need to see a significantly higher potential return to accept a more high-effort investment, such as becoming a landlord.
Before investing, think about your risk tolerance and goals. Then, look for opportunities that offer a mix of risk and reward that lines up with what you're trying to accomplish.
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