How long, with what objective, and what level of risk are we willing to take. These are the first three questions we need to consider before investing. After that, we need to decide on a portfolio and remember the importance of psychological factors.
What should you analyze before investing?
Before you start investing and selecting assets that align with your criteria and goals, it's essential to address three key aspects; without these, you can't develop an effective investment strategy.
- Time frame
Although it doesn't necessarily have to be the first issue you resolve, it's just as crucial as the following two. The initial step is to determine the time frame in which you’re willing to set aside this money to achieve additional returns.
If you need the money in a year for something like buying a car or a house, you'll need a different investment approach than if you are looking at a long-term horizon.
- Goal
After deciding how long you want to invest your capital, the next step is to identify your investment goal. You might simply want to counteract the effects of inflation to maintain your purchasing power. Alternatively, you may aim for investments that yield 7% or more annually over a specific period.
The key point here is to understand that higher returns come with higher risks. For example, aiming for a 2% annual return involves significantly less risk than targeting 8% or 10%.
- Risk profile
Equally important is understanding your risk profile. There are numerous online tests that can help you gain insight into your risk tolerance. Knowing this is a crucial step. Before building your portfolio, you need to know how much volatility and risk you can take. If you have a conservative profile, you might lean towards fixed-income products. Conversely, if you have a more aggressive profile, equities could be more suitable.
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Where to invest?
Once you've addressed these three questions, you can start exploring the range of available options to build your portfolio, while understanding the criteria and features of each investment choice.
- Fixed income
Fixed income is a popular choice among investors, particularly those with conservative or moderate risk profiles. However, it should be included in all types of portfolios, with the allocation adjusted based on your risk tolerance and investment goals.
Investing in fixed income involves lending money to a government or corporation with the expectation of receiving interest payments plus the principal amount. A crucial factor to consider is the creditworthiness of the debt issuer. Lending to a country like Germany is not the same as lending to a small, unknown company. This is where the risk-return trade-off comes into play.
In the fixed income market, you should pay attention to the issuer's credit rating, but that's not all. Consider the bond's maturity, its liquidity, and the interest rate. If you plan to hold a bond until it matures, you need to know whether it is a 2-year or an 8-year bond, and understand the liquidity of the asset in case you decide to sell it early in the secondary market. Lastly, the interest offered by the issuer should align with your return objectives. For instance, if your goal is to keep up with inflation but the bond pays only 1.5% annually, you might fall short of your target.
- Equities
When it comes to equities, the criteria you need to consider are quite different and will vary depending on whether you’re investing directly in stocks or through products like ETFs (exchange-traded funds) or mutual funds. Regardless, you need to understand various factors including the company you're investing in, the country, the industry it's part of, its competitive landscape, and a financial analysis to gauge the business’s valuation relative to its stock price.
If you choose to invest in individual stocks, you'll need a more detailed and comprehensive analysis of the company's accounts since you'll be purchasing shares of a specific company. This step demands a higher level of investor expertise.
For ETFs and mutual funds, although the criteria aren't as detailed, you still need to consider them. You should focus on the companies, countries, and sectors that the fund invests in. Purchasing an ETF focused on a specific country like India is different from one centered on a particular sector like cybersecurity. Each scenario requires a unique approach to analysis.
Commodities
Lastly, another major group: commodities. Commodities, or raw materials, encompass a wide range of products like gold, oil, coffee, and even orange juice. Each comes with specific criteria that you need to understand before investing. Gold, for instance, is often seen as a safe-haven asset, providing inflation protection and stability to a portfolio.
On the other hand, products like steel or copper are tied to industrial demand. These metals generally perform better during periods of global economic growth, while agricultural products like cocoa, coffee, or orange juice are significantly affected by weather conditions.
Overall, commodities tend to be quite cyclical, meaning their performance can vary over different time periods. The criteria for evaluating each commodity differ based on unique factors. For example, gold typically performs well during economic downturns as it is used as a hedge, whereas oil benefits from economic expansions due to increased mobility.