Investing - Part Two
Continuing with the most important criteria to evaluate when looking at a potential investment…
Fair Price / Fees
People sometimes don’t care too much about fees due to how small they seem compared to the amount of money invested. However, fees are one of the main reasons why some investments do not reward investors as expected. A lot of small fees charged month after month can eat a big hole through your investment returns.
Fees should be calculated as a percentage of the total money invested. So if a mutual fund charges you $1 for every $100 you invest with it, that’s a fee of 1%. If they charge a flat $2 fee on top of the $1, then you are paying 3% for the $100 invested.
Too often investors are too busy chasing a higher ROI without looking closely at all the fees that come with the investment choice. Compare the two investment choices below:
Sophisticated hedge fund: 13% ROI, charges 2% of your assets plus 20% of any profits
Passively investing in an ETF: 9% ROI, zero fees
Despite the much higher ROI, $100,000 invested in the hedge fund returns $203,121 after 10 years and fees, while the same $100,000 invested in the ETF returns $217,189. As non-intuitive as it may be, the much superior ROI was completely eroded by the higher fees that came with it.
An investment firm managing $10 million and charging 1% makes $100,000 per year. For them to start making $200,000 per year, they can either produce a higher ROI, and grow the file of money to $20 million, or raise the fee from 1% to 2%. Since achieving a much higher ROI is a pretty tough challenge, more often than not it’s the fees that get raised.
It’s reasonable for investment products to charge a fee, after all the companies selling them need to keep the lights on. Just remember that excessive fees are the bane of your investment results. For a general rule of thumb, be careful of management fees above 1%.
Liquidity
Liquidity is a fancy word for describing how quickly you can buy or sell the investment at any moment. The obvious benefit for very liquid investments is the ability for you to freely move money around, for alternative investments, spending, or rainy days. However, there are also benefits to less liquid investments as well.
Suppose you purchase a $500,000 house with $100,000 down and rent it out to someone else. Let's say after mortgage payments and other expenses, you get to keep $800 per month from the rent you collect, plus an additional $1,000 in equity value (equity = ownership in the home, which increases as the mortgage gets paid off).
Over a year you are rewarded $21,600 (9,600 cash and 12,000 equity value) from this investment. Given your initial $100,000 investment, that’s a very respectable 21.6% ROI. Despite its low liquidity (you can’t trade houses the same way you trade stocks), this is a home run of an investment that will do wonders for your financial growth.
Understanding
Most of us will do 50 hours of research before buying a $2,000 fridge or oven, but invest $10,000 into a random stock because of “research advice” from pundits on TV or YouTube. The difference is that a poorly researched oven will probably still do its job, but a poorly researched investment can delay your retirement or your dream house for years. So please, do as much research as possible, and only make investments in things you fully understand.
If you are investing in individual stocks, pull up their annual reports, look through their financial statements, and read the executive comments. Look at the industry dynamics, and think about how the company will fare against the competition.
If a salesperson approaches you with a life insurance or some other financial product while making all kinds of wonderful promises, ask him for a list of all the fees, and ask him how they will deliver the promises. Sit down on your own time, scrutinize the product carefully, and look over every single fee they might hit you with.
If what we just described sounds confusing, there are two things you can do:
Teach yourself how to do this kind of analysis (for example, look up tutorials on how to read an income statement, how to do a DCF analysis, etc)
Give your money to professional managers who can do the work for you
If you hire professionals for help, be very, very careful to make sure they are ethical (putting your interest first), and aligned with your own beliefs (for example, if you are a patient long-term investor, don’t hire someone who loves day trading).
Words of caution:
We know some people aren’t fans of Warren Buffett’s older investment style, but he is still the best investor in recorded history. When asked by a USC student on how to build wealth, he gave this response:
“I could give you a ticket with only 20 slots so you had 20 punches, representing all the investments that you got to make in a lifetime, and once you’d punched through the card you can’t make any more investments.”
With this rule, the student would have to think very carefully about each investment, only picking the ones he fully understood after thorough research and investing with conviction in those select opportunities.
While you may not implement the 20-Slots Rule by the letter, it is a crucial mentality to have. In your lifetime, you will see thousands of investment opportunities, 99% of which will be garbage. Your goal is to be a sniper on the field, doing tremendous research while patiently waiting for the right target.
Up Next…
In the next article, we will discuss the most common forms of investments as well as some not so often talked about types of investments. Join us as we break down their pros and cons…
