Updated: February 5, 2020
There are hundreds and thousands of investments out there. How do you choose the best one? Do you simply search for and then put your money on the investment with the highest returns?
Well, the answer is both yes and no.
Yes, you should do research to find the investment with the best performance. And no, it’s not as simple as just doing that, because there are things that you need to do first before actually investing.
What are those things? That’s what this article is about. So read on and find out.
Personal finance is personal.
There is no such thing as the best investment. There are only investments that are best fit for you.
Personal finance is personal. This means your financial decisions should be based on your personal circumstances. It should be based on who you are, your financial capacity, and more importantly, your personal goals in life.
It’s a common mistake to simply copy what others are doing; to invest where others are investing.
Oftentimes, a misalignment happens when you do this. Investing on something that’s mismatched against your personal finance can lead to financial disappointments later on.
That’s why it’s important to carefully follow these steps when choosing the best investment.
Step 1: Define your financial goals.
Investing is saving up for a future expense. So it’s important to know exactly what that future expense is.
And more than the goal, you should likewise decide on the target date and how much money you’ll need to achieve that goal.
For example, let’s define two financial goals:
- A fund for an out-of-town vacation that you want to take 10 months from now. For this, your estimate is that you’ll need a budget of around P20,000.
- Prepare for your child’s college education, who is graduating senior high school within 8 years. And based on current tuition prices plus inflation, you’ll need about P600,000 for this.
Reminder: Never invest without a goal. And if you can’t think of any, remember that you need to prepare and invest for your retirement.
Step 2: Determine the type of investment you need
Now that you have your financial goals, it’s time to determine the type of investment you need with respect to them.
Basically, investments have three main features:
- Liquidity – an investment that’s easy to convert back to cash
- Growth – an investment that can grow significantly over time
- Income – an investment that can generate regular cashflow
It’s important to understand that a specific investment won’t have all these features. For example, a real estate investment’s value can grow significantly over time, and it can generate rental income for you. But it’s hard to sell it and convert back to cash. It’s not a liquid investment.
Moreover, investments can be defined by their duration:
- Short-term – an investment that’s less likely to go down within 2 years or less
- Medium-term – an investment that can possibly grow within 2-5 years
- Long-term – an investment that can achieve significant returns after 5 years
Given these, you can simply match the investment with your goal’s target date. For example, if you plan to use the money within 3 years, then you will need a medium-term investment.
Given our two goals above, we can now determine the type of investment you need:
- Vacation Fund — a short-term investment with liquidity and growth
- College Fund — a long-term investment with growth
Why do you need liquidity for your vacation fund? Given that you only have 10 months left, you’ll need to be able to convert the investment back to cash easily, especially when suddenly, there’s a seat sale and you need money to buy the bargain plane tickets.
On the other hand, because the college fund is a long-term goal, then liquidity isn’t a necessity because you’ll have several years of opportunities to find the best time to liquidate the investment.
And then, how about a Retirement Fund? Assuming you’re still very far from retirement, then you’ll need a long-term investment with growth and income.
Step 3: Know your risk tolerance.
How are you when it comes to risk?
Do you get anxious and stressed when you see your investment’s value go down? Then you should simply go for low-risk investments. But if market fluctuations don’t bother you much, then you have an aggressive personality that’s suitable for high-risk investments.
Ideally, a short-term goal would call for a low-risk investment; a medium-term goal would be for moderate-risk investments; and a long-term goal can be matched with high-risk investments.
But again, personal finance is personal. And you should listen to what your heart and mind prefers.
Going back to our sample goals, and assuming an ideal scenario, then we can now add the type of risk:
- Vacation Fund — a low-risk, short-term investment with liquidity and growth
- College Fund — a high-risk, long-term investment with growth
Step 4: Find the best investment that matches your needs.
Now is the proper time to do research and look for the investment with the highest returns. But IT MUST also meet the criteria you’ve defined.
For our Vacation Fund, an example of a low-risk, short-term investment with liquidity and growth is a Money Market Fund. You can also go for a high-interest bearing bank deposit account.
You can check out the historical prices of Unit Investment Trust Funds and Mutual Funds in the market and invest in the best performing Money Market Fund for the past 3 years or so. Or, you can choose to open a savings account in a digital bank, which normally offer the best interest rates per annum.
On the other hand, an example of a high-risk, long-term investment with growth potential would be the Stock Market and Equity Funds. Do the same research on historical performances and invest there for your child’s College Fund.
Step 5: Calculate how much you should invest to reach your goals.
Once you’ve chosen where to invest. The final step is to calculate how much you need to invest. For this part, you’ll need to understand key concepts on the Time Value of Money, which I’m leaving as topic for another day.
But of course, you can simply open a spreadsheet document and simulate your investment’s growth. I suggest that you do cost averaging and see what happens if you invest a fixed amount every month until you reach your target date.
In our example, assuming that you chose to invest in a Money Market Fund that has an average growth rate of 4% per year. Then you should be able to compute that you’ll need to invest around P1,970 every month to achieve your goal of having P20,000 after 10 months.
Furthermore, if you chose to invest on an Equity Fund with a historical average growth of 12% per year, then you’ll need to invest around P3,630 per month for 8 years to have at least P600,000 by the time your child enters college.
The 5 steps listed above is a basic overview of how to choose the best investment. Or rather, how to choose the investment that best fits you and your financial goals.
If you want to read more about this method, then you can check out my book, The Ready To Be Rich Guide to Investing. In there, you’ll learn more details on how to implement this method and strategy.