Two big errors when investing and how to avoid them!

 

I have read an article about an investor that obtained indemnification for the losses incurred in view of advice rendered by a non-habilitated professional.  This professional was an agent, a distributor of financial products. Interesting and didactical to listen to the explanation provided by this “newbie” investor:  

• How can I discuss (the investment in stocks) if I do not understand it? and
• I invested in stock my company’s working capital!

In the provided explanation two primal errors are identified. The first error is that of investing in something one does not understand. If one does not understand it is impossible to judge, and, eventually make a rational investment decision. Any investment has embedded in its rate of return a risk. Meaning, that higher the return, higher the risk of the investment (or project)! An investment in stocks is of variable return as it may generate returns above or below the reference rate. The result of such investment is never known at the moment it is made. Reference is that low risk tending to zero rate.

The second error is that of financing long term investments with short term funds. When investing in stocks, one buys a parcel of a company. Except if the person has privileged information (which is illegal) or luck, the return on the investment will take place in the medium and long terms. Cash that is needed in the short term or that are “counted” (cannot bear a loss) cannot be invested in stocks.

These two basic errors must be avoided, also in the corporate world:

(1)    First, one must avoid approving investments in projects that one cannot understand, or that one does not know how these projects will generate value;
(2)    Secondly, one should not fund medium or long term returns projects with short term funds. This latter error is very common.  Companies invest in buildings, machines, plants, stores, using short term funds and in by doing this, taking the company closer to a liquidity or solvency risk!

The use of an Investment Proposal model if does not eliminate risk at least creates a rich and productive opportunity for discussion and analysis.

“Only simpletons believe everything they're told! The prudent carefully consider their steps.” (Book of Proverbs)