When investors are evaluating a potential investment opportunity there a number of factors they must consider. Sometimes investors can be overwhelmed with all of the information, leaving them confused and often frustrated. They are bombarded with advertising, cold calls, and seminars from the financial services industry and often leave these experiences with more questions that answers.
The following principles can help all investors understand how to evaluate a potential investment opportunity. These principles pertain to both those individuals who are still accumulating their assets and those who are faced with the challenges of generating income from their assets after a lifetime of work.
Principle 1: Potential for Greater Return Means Potential for Greater Risk
When evaluating an investment opportunity understanding this principle is a must. Terms like “safe,” or “risky” are too vague and can often be quite misleading.
Investors should utilize this simple formula when determining whether or not and investment is appropriate for their portfolio.
(Anticipated Return on Investment) – (Ten-Year Treasury Interest Rate) = Additional Relative Risk
For example, if the potential return on investment X = 10% and the current ten-year treasury is paying 5%, an investor is assuming twice the risk in investment X as opposed to the ten-year treasury.
Investors must ask themselves if they can accept that risk. As an investor you should know the level of risk involved in every investment and determine whether your portfolio can accept that risk.
Although this principle may sound straightforward it is very often overlooked by the lure of high double digit returns.
Stay tuned for Principle 2: Every Investment Decision Has Risk.