Knowing how to make investment decisions is hard. The decision making process itself can be a major barrier, especially for anyone new to investing, and one so big it’s potentially crippling.
Being worried about making the wrong move can stop you making any moves at all.
Although there are always many factors to consider before investing in anything it’s your overall mindset and strategy that’s going to help you make a decision and hopefully the right one.
It’s my aim within this post to help you alter your mindset which will ultimately enable you to make investing decisions from this point onwards.
In the process I’ll also give you my 5 key factors to consider before making any investment.
Investing Decisions: The Fundamental Problem
At it’s core the fundamental problem with making investment, or any financial, decisions is that we don’t want to lose money.
For most the worry of losing money outweighs the allure of making it (the Loss Aversion Principle).
So much so that there are academic studies which show people feel losses twice as powerfully, on a psychological level, as they do gains.
Ref: Advances In Prospect Theory: Cumulative representation of uncertainty
At the start of my own investment journey I was no different and it took a number of years to overcome these concerns.
Deciding Where To Invest: Change Your Mindset
This section is long but it’s crucial so read it, re-read and make sure you understand it. No skimming allowed!
The problem with deciding where to invest and subsequently being stuck trying to make that decision actually comes more from your mindset than the specific investment you’re considering.
Why?
Quite simply because you’ve got too much on the line. Let me explain…
The vast majority of people struggling to make investment decisions do so because they have a pot of capital to invest and they are trying to decide where to invest it ALL.
They are investing everything they have saved in one go into one asset.
If that asset has a 60% chance of making money (40% chance of losing) it’s still a good investment but 40% of the time it won’t feel like it.
If your investment does lose money chances are you’ll be put off investing all together.
Your New Mindset…
There are two key concepts to becoming a successful poker player and both apply in exactly the same way to investing.
These are variance and positive expectation.
Variance: if you toss a coin 10 times in theory you should get 5 heads and 5 tails. In practice this rarely happens over such a small sample and any result that isn’t a 50/50 split between heads and tails could be considered variance.
Positive Expectation: for a bet or investment to have positive expectation you must stand to win more frequently than you lose. If you place a £10 bet at even money (so you stand to profit £10 or lose £10) on an event with a 60% chance of success then you have positive expectation. Make the bet 10 times you’ll win 6 (£60 profit) and lose 4 (£40 loss) leaving you up £20 overall.
Investments are the same as bets. The majority have a positive expectation but variance means you won’t win every single time you make one.
You need to understand that you can make a good decision and still lose money because that decision has a positive expectation.
Now imagine you split your pot of investible capital into multiple different investments all of which you still believe have a positive expectation (more chance of making money than losing it).
You find yourself in a position where a couple of your investments can lose money but overall you’ll still make money.
By thinking in this manner your free from the overbearing worry that the one decision you’re going to make will turn out badly.
Essentially you are diversified.
Factors To Consider Before Investing In Anything
Once you’re freed up to make investment decisions without being overly worried about the outcome, because you’re not putting all your eggs in one basket, you still need to consider a number of factors before pulling the trigger.
5 Key Factors I Consider Before Investing In Anything
1 – What is the investments expectation?
Does this investment have a positive expectation (is it more likely to make money than it is to lose money)? What does this expectation look like in real cash vs amount of capital invested modelled at varying degrees of success.
An example of this might be running numbers on a buy to let property with differing end valuations and monthly rental incomes. Modelling these scenarios lets me see how much money I might make or lose if x, y or z happens.
2 – What is my maximum downside?
I already know my potential upsides from looking at the investments expectation but for me it’s also essential to know the maximum downside I could face if this investment goes badly.
In my opinion it’s impossible to understand the true risk you’re taking without trying to calculate your worst case scenario.
If I’m investing a chunk of capital into an index fund for example, what would that investment look like if the market underwent a record breaking crash and how long would it take for my investment to recover on the back of that event.
Can I afford my maximum downside? If not I’m essentially gambling and that’s not something I’m looking to do.
3 – How much risk is there?
Leading on from modelling my worst case scenario I want to understand the risk associated with this investment.
I make sure to fully understand the type of risk associated with the decision I’m making.
That risk could be stock market volatility, not meeting rental targets, long void periods for any property, low occupancy for a holiday let or serviced accommodation unit, a start up going broke, a property developer overrunning on their agreed payback schedule… it depends on the investment you’re making.
Whatever the risks are I want to understand them fully before deciding if I’m comfortable with them and they are worth taking.
4 – What does the yield potential vs time requirement look like?
Time is a finite resource and before making any investment I want to first know how much of my own time is going to be taken up by this specific investment.
Expanding from that I then compare what the yield potential is vs the time investment that is required in an attempt to weigh up whether or not the investment is worth it when we factor not only potential returns but also time into the equation.
For example property A needs a back to bricks refurb which will take 3-4 months to complete but yield 10% once fully let. It’s a time intensive project with many different stages to manage.
Property B needs a light refub and could be let out within 4 weeks but will only yield 7%.
The choice between the two deals in the above scenario will really depends on my other time commitments (including time away from work). The bigger yield is more attractive but at what personal cost is that coming? Is it one worth paying?
5 – Are There Any Non Financial Upsides?
I think most investors forget to consider non financial upsides to their potential investments and for me these can be equally as important as making money.
It’s often non financial upsides that sway me one way or the other on an investment.
A great example of this could be adding a holiday let to your property portfolio with the intention of utilising it yourself. In my opinion it’s fine to sacrifice some yield in exchange for the personal upside your getting from a deal like this.
Another example might be taking on a property that requires more money left in the deal or doesn’t have fantastic yields because of the experience you will gain working on it. I’m thinking doing something you haven’t done before and learning in the process here… a commercial to residential conversion or ground up new build for example.
Related Reading:
I covered a lot here in a short space of time but I’m hoping that realising you can split your capital across multiple investments will really help you pull the trigger on more investment opportunities.
The following are posts I’ve written which make good follow on reading around this topic:
- How To Structure Your Investment Portfolio – a deeper dive into how to diversify your investment portfolio to avoid over exposure to one specific element.
- Stocks vs Property – Which Is Better? – a post which compares the two investments and looks at the pro’s and con’s with a focus on passivity and time input requirements.
- How To Find A Financial Advisor – some guidelines on how to find a financial advisor if you still feel you need more help with your decision making.
Leave a Reply