In my recent The Secret to Making Money – Positive Cash Flow article I indicated the simple secret to making money is positive cash flow. In this article, I lay out the two questions I ask before investing money. These questions are:
- Will this investment generate a level of return commensurate with its level of risk?
- Would our standard of living be negatively impacted if the investment lost 100% of its value?
Return Versus Risk
Everybody has their personal reasons for investing money. If you, however, delve into the underlying reason why you invest money it likely boils down to the desire to increase your family's purchasing power or to provide you and your family a greater degree of financial comfort.
We sometimes can lose sight of this. This is why it is exceptionally important to write down your objectives and goals and to frequently review them. This way, you reduce the temptation to do something that will set you back from achieving your objectives and goals.
A good way of looking at this when it comes to equity investing, or other forms of investing, was shared by Lawrence Cunningham when discussing Warren Buffett (chairman and CEO of Berkshire Hathaway). In a nutshell, Cunningham states an investor's objective is to think about management, products, services, competitors, and capitalization structure. As you run through this analysis, the primary question you, as an investor, need to answer for yourself is:
“Can I, with a reasonable degree of certainty, expect the after-tax return on my investment to at least equal the purchasing power of my initial investment plus a fair rate of return?”
In essence, your potential investment should offer:
- a very high probability of returning the real inflation-adjusted purchasing power of your initial investment AND
- adequate compensation for your risk and the time you had to forgo the use of your capital instead of deploying it for other purposes.
The primary relevant factors you need to consider in your investment analysis are:
- the long-term economic characteristics of the business;
- management quality and integrity; and
- future levels of taxation and inflation.
Regardless of the nature of the investment, you must try to answer in the affirmative the question reflected above.
Naturally, every investor is different. We each use our respective knowledge, areas of expertise, and temperament. An investor with extensive experience in the North American railroad industry, for example, will very likely have far greater insight into the recent Canadian Pacific Railway Limited (TSX: CP, NYSE: CP) and Kansas City Southern (NYSE: KSU) merger agreement announcement than someone employed in the oil and gas sector.
Impact of an Investment Losing 100% of its Value
Losing 100% of your investment in Johnson & Johnson (JNJ) is possible. There is always a probability you may suffer a permanent impairment to your capital. What differs, however, is each investment's probability of loss. Clearly, a JNJ investment is far less risky than a junior mining company investment.
Having reached financial independence, I don't care how lucrative an opportunity appears. There is just no way I would ever invest in something that would place my family in the position where we have to start all over again.
Everyone needs to remember the unexpected occurs when least expected. If you plan to prosper, you must be able to financially survive the unexpected.
As a Commercial Banker in the early 1990s, I witnessed clients who appeared to have the world in the palm of their hands. It became readily apparent, however, that some had overextended themselves. Some customers suffered tremendously when recessionary times hit and a decade later had yet to fully recover.
In the case of Warren Buffett and Charlie Munger, the cash generated from Berkshire Hathaway’s operating companies provides a steady stream of capital for redeployment. The Berkshire Hathaway economic engine essentially continues to churn out new capital to take advantage of opportunities. We need to manage our personal affairs the same way Buffett and Munger manage Berkshire Hathaway.
There is a temptation to get rich faster once you reach the stage where you have more money you need in a lifetime. This is all well and good if you can do it without introducing the risk that would force you to start all over again. Decades of intelligent stewardship, disciplined saving, and wise investments are too important or valuable to be interfered with.
Financial freedom is a journey. Whatever you do, avoid wipe-out risk that will force you to start over your journey.
I wish you much success on your journey to financial freedom.
Thanks for reading!
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Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.