In today’s world, there are many different options amongst several asset classes to invest money in.
While the return on your investment plays an important key role in what makes a good investment, there are definitely other qualities that a favorable investment should have as well.
If for instance, you are promised to receive a 200% return on your investment every year but the chance for you to lose everything instead is 80%, would you consider that a good investment?
Probably not and this is why the return may not necessarily be the only quality to look for in an investment. So what exactly makes a good investment?
A good investment should be able to consistently provide high returns in relation to a low amount of risk and high liquidity, but in the end, the best investment is the one that suits you the most.
1. Healthy Amount of Risk
Risk assessment is extremely important to the process of investment evaluation. If you don’t have any idea of the types of risks that come along with an investment, and how much the amount of risk it holds, chances are that you won’t be able to make a great and consistent return over time.
In general, you are not only exposed to one but several types of risk as soon as you make an investment. Being aware of those types of risks can be crucial, as they may heavily influence the return of your investments over the long term. Risk factors should play a big role in your decision making.
Types of risk that generally apply when investing include:
- Market risk. There is always the risk for an investor to suffer a loss from the overall performance of financial markets, even if your investment isn’t directly affected by the cause of the loss. Anything that can affect the performance of financial markets such as political uncertainties, recessions, terrorist attacks, or changes in interest rates are contributing to the market risk.
- Liquidity risk. Usually, the smaller the size of the security, the larger the liquidity risk. Liquidity risk is the risk that a certain period of time may occur, where it’s hard to convert the investment quickly into cash when needed. The tight liquidity of an asset can force owners to sell their investment at a lower price than what it is actually worth.
- Inflation risk. Inflationary risk is the probability that the return of an investment won’t exceed inflation for a certain period of time. An investment of today will decrease in real value if the inflation rate in the given time is higher than the rate of cash flow that the investment produces. High inflation can be very painful for investors, as it essentially undermines all investments that aren’t providing a greater return.
Also, a very important and beneficial quality that a great investment should have is liquidity. The easier it is to convert an asset into cash the more liquid that asset is being considered. Assets that have low liquidity may be hard to sell for their true values, which can cause a lower than expected investment return.
While stocks and bonds are highly liquid as they can mostly be sold at any given time, assets such as real estate or jewelry are not as liquid because it can be hard and time-consuming to find a buyer to convert them into cash.
Ideally, you want to have investments that you can sell and convert into cash quickly at any given time.
3. Good Return
People are investing because of the potential return that they are expecting to earn in the future. There simply wouldn’t be any investing if it wasn’t for the return.
The higher an investment’s return the more profit there is possibly going to be obtained by the investor. But what exactly is nowadays considered as a high but realistic return?
When it comes to investing, it is crucial to understand that every percentage point matters and will have a noticeable impact on your wealth in the long run. This is due to the power of exponential growth.
If you manage to double the percentage of your return, it certainly doesn’t mean that your final outcome will double.
Let’s assume that you invest $1000 with an annual return of 10% over the next 50 years. After 50 years you would end up with about $117.390 in your bank account.
Now let’s suppose that you invested the same $1000 but with a 20% return for the same 50 years. After 50 years those $1000 would turn into a staggering outcome of about $9.1 million. This is all caused by exponential returns.
The stock market (S&P 500) is expected to provide an average annual return of about 8% over the long term. This makes stock investing in general to one of the asset classes that provide the highest returns.
Nowadays it has become easier than ever before to acquire shares of companies. Legendary investors such as Warren Buffett or Peter Lynch have even managed to achieve far greater returns than the average.
But even if you achieved the average stock market return, for example, by investing in an index, you would be able to massively grow your wealth over the long run.
What You Should Look for in an Investment
The criteria mentioned above play primary roles in what a good investment needs to have. In the end, it is completely up to you and your current and personal circumstances to define what makes a suitable investment for you.
Everybody is going to agree on the fact the higher return the better. The problem is that in practice, those criteria are going to suppress each other. Usually, what comes with a high return also brings an increased amount of risk or any other traits with it.
Unless you determine yourself to put the required amount of effort and time to find both low risk and highly valuable investments, you will mostly be faced with either high-risk and high-reward or low-risk and low-reward investments.
Stocks, for instance, are generally considered riskier but offer good returns, while bonds are usually less risky but provide lower returns.
Some investors can find great investments with good risk to return ratios in almost all kinds of market conditions. Not every investment is going to be more likely to deteriorate, as soon as a higher return is given.
But finding those kinds of investments can be extremely hard at given times, such as in periods of high economic growth where many assets tend to become overvalued. It is definitely possible to achieve market-beating returns in the long term including low amounts of risk to be taken but not everyone has the time and commitment to find such investments.
You could ask yourself several questions to determine which criteria you want to aim for in an investment:
- How much risk am I able to bear?
- With what amount of return would I be satisfied?
- What does my investment horizon allow me to invest in?
For example, if you are still in your early life stage, you may be able to take on more risk and thus possibly higher returns than someone who expects to go into retirement soon. As in every other case, it is important to adjust the expectations of your choices to your personal circumstances.