I sometimes get friends asking me about what they should invest in. What I usually do in response is to tell them that you need market research to identify opportunities that have potential for high returns. But they should pursue these opportunities only if they meet three criteria. And I will share them here.
1. The returns should be higher than the risk-free rate
Let’s assume you had the option of putting money under your bed and in a year’s time, you will get that money back plus interest of 22%. And let’s assume this was fool-proof. I doubt you would be willing to lend money to anybody at less than 22% since you could always generate a 22% return just by placing the money under your bed. You will certainly look for a higher return before you lend.
The 22% return is what is known as a risk-free rate. And in the real world you don’t get it from putting your money under the bed, you get it from lending to government. By buying government securities like treasury bills or bonds you earn a risk-free return because the government can always print money to pay you back. In that case for you to invest in something else, the potential returns from that investment must be higher than the return that you can earn by lending to government.
2. You should be able to get out when you want to
I’m not arguing that you should not invest for the long term. Far from it. But any investment that locks up your capital for long periods can cost you better investment opportunities when they arise or can leave you vulnerable in emergencies. One way of getting around this when investing long-term is to invest only money you can afford to do without for long periods. For money which you could need at anytime, invest in assets which are liquid i.e. they are easily convertible to cash.
3. Don’t bother about sunk costs
Let’s say you spent GH¢10,000 on buying a state-of-the-art mower because you want to start a landscaping business which you calculate will give you a profit of GH¢1,000 per month. Let’s also assume only you can operate the mower, so no one else would buy it and you can’t hire anyone to operate. Let’s also assume it would take all the time you’re willing to work in a day to operate it. Now just as you are about to start your business, someone comes to offer you a job which would pay GH¢1,200 a month after you’ve deducted all your costs. Assuming your goal is purely financial, should you accept the job? Yes, of course!
You may be asking if accepting the job would not mean that you have thrown away the GH¢10,000 you invested in buying the mower. Well that GH¢10,000 becomes what is known as sunk cost. It is cost which has already been incurred and therefore is irrelevant to future investment decisions. Whether you start the landscaping business or go for the job, you’re not getting the GH¢10,000 back. The only thing that matters now financially is which of the options gives the higher return. And the job does, so you should go for it.
Of course when one gets down to specifics, deciding to invest comes with many more factors to analyse. But these 3 general rules make sense in every case and will hopefully save you from making financially unsound investments.