Principle #8: Match the Right Instrument With the Right Requirement
Okay, this principle doesn't sound so catchy. For sure, the familiar warning "If it's too good to be true, it probably is." plays better on the ear.
But it doesn't quite capture what's most important when it comes to investments. When it comes to investing your money, the key principle to remember is "matching". This should guide you when making investment decisions.
If you don't match your investments with your requirements, you'll end up making poor choices. When I started investing, all I knew was that stocks was the way to go. So I invested in stocks with no particular objective except to save and invest "for the future".
But I should have taken into account my immediate needs, like wedding expenses and a mortgage. That way, I should have invested in bonds, government securities, and other fixed income instruments.
Matching investments with specific needs helps you determine how much you should expect and can take (risk and return), how much to invest (asset allocation), how long to be invested (time period), and what to avoid (speculation and scams).
Risk and return
Everyone has a different appetite for risk. Some are conservative investors who only keep their money in safe instruments like bank deposits and government securities. Others are risk takers, putting money into speculative stocks and even get-rich-quick schemes. Most of us are in between.
But our risk attitude as investors and our expectations for returns should really take into account our goals. Example, if you were planning for retirement, then investing in equities, which has a higher risk, is an appropriate decision. Putting money in bank deposits is not a good idea because inflation will eat up your measly returns. There's no way you'll accumulate enough wealth for retirement purposes if you're too risk averse.
In the same way, if you're saving for a downpayment for a car loan by next year, you shouldn't be investing in stocks. Don't expect double-digit returns in a short period of time if your goal is short term. Even if you have a high appetite for risk, you should be guided by your specific need.
Asset allocation
How much of your money should you put into stocks, bonds, real estate, money market accounts, government securities, and cash?
It all depends on your goals. If your goal is something immediate and you don't want to risk losing your principal, then allocate money into short term and relative safe instruments. If it's long term, then allocate more into equities.
Time period
Now, how long should you keep your investments? Again, if you have no particular objective for your investments, and you're invested in stocks, you may be easily tempted to pull out when the market goes down. But if those investments are for the long term, then you can ride the ups and downs of the stock market.
If you have short term needs but you invest in long term instruments, you may end up losing money if you're forced to sell your investments.
If you have long term requirements but you just invest in short term instruments, you may risk not earning enough on the smaller returns.
Speculation and scams
Lastly, this principle should guide you in avoiding get-rich-quick schemes and investment scams. If your need is to protect your income, then you certainly shouldn't play with speculative investments, and worse, potential scams.
If you have play money you don't care to lose (lucky you), then putting it in high risk investments is a gamble, as long as you know what you're getting into. Still, I don't encourage it. Wasting money, even play money, is still a waste.
So, if you have money to invest, go back to the financial goals you set (remember the exercise we did before?). What is it you want to achieve first? When you determine your need, you can now make the right choice on what type of investment can best meet that need.
