Life is full of risks. Some risks like having surgery or driving on the highway are unavoidable. But even though some risks cannot be avoided, they can be greatly reduced by eliminating the unknown. In the case of having surgery, you will be much better off knowing the background of your surgeon, her success rate with the operation, as well as her reputation and medical standing. By driving defensively and knowing your route ahead of time, you reduce the risk of accidents. By doing your homework up front and identifying the issues and eliminating the unknown, you can better understand your limitations and manage risk.
To handle your money and investing successfully, some fundamental homework is also needed. First, take stock of your financial fitness. A few evenings at the kitchen table with a year’s worth of cancelled checks, credit card receipts and ATM withdrawal slips will provide you with enough information to create your balance sheet and income statement. This hard knowledge of facts and figures will help you determine a rational plan for budgeting, planning and investing.
Money is intimidating. Making decisions about money is even scarier. In your home, on your job or in your business, you make decisions all the time without hesitation. You control, to the best of your ability, your fate. You strive to have the freedom to make decisions about the direction your life is going, how you spend your days, how you spend your money.
We’ve all taken risks at one time or another and succeeded. The risks were controlled. We try to avoid stupid decisions. We do our homework. But so much falls through the cracks when it comes to money.
It’s all a matter of knowledge. That doesn’t mean knowing the answer to every question. It means knowing to ask questions. It means eliminating as much of the unknown as possible. And when in doubt, subject your proposed investment to the following tests:
The Risk Test: If you awaken at night, concerned about the safety and permanence of your investment, you have assumed too much risk. Hype, glamour and excitement in investments more often than not are the result of smoke and mirrors. At different stages in your life, some risk may be acceptable. It will depend upon many factors including your net worth – there is no substitute for wealth – and your emotional capacity to weather uncertainty.
The Gambling Test: If you have the urge to gamble with your money and wish to speculate, take $300, go to a casino and get it out of your system. The stock market is neither a savings bank nor a casino substitute. Investing requires diligence, patience and discipline.
The Broken Egg Test: No matter how wonderful an opportunity sounds, never place all your assets in one basket. Diversification is the magic word. Every portfolio must be diversified to reduce the overall risk. To buy one municipal bond or one stock is foolish. If you can only afford that one investment, you don’t belong investing. Some mutual funds though, can satisfy many investment needs of the small investor. A quality fund with stable management, a good history, and reasonable operating expenses is inherently diversified even for those who are investing a small amount of principal.
The Microwave Test: If you spent as much time organizing, planning and learning about your money and investments as purchasing a microwave, you would be in good shape. The purchase of a microwave is a $100 decision that only affects the speed at which you can make a melted cheese sandwich. Yet, many people will be easily swayed to plunk down $10,000 because of a slick, high pressure sales pitch about an investment they know nothing about. The Internet, libraries, bookstores, magazines and cable TV are crammed with information on investing. Money magazine is another good place to get a feel for the language and basics of investing.
The Professional Test: When you are ill, you seek medical advice. When you are stymied with your tax return, you seek an accountant. When you need financial assistance, find a good financial advisor. Follow the same steps to find a financial advisor as you would a dentist. Ask your friends for referrals. Check the advisor’s credentials. Ask for references.
The Final Test: Preserve your capital. Keep pace with inflation and protect your purchasing power. Don’t expect miracles and home runs overnight. Don’t do anything that doesn’t make sense and feel right.
The mere thought of investing may seem risky to you. Investing and risk need not be synonymous. But risk is relative. Doing nothing is very risky. Doing your homework, following these straightforward rules, and expanding your knowledge reduces risk dramatically.
