Understanding Investment Risk

With respect to investing, the phrase caveat emptor—“let the buyer beware”, certainly applies. But at the same time, investing need not be as risky as, say, a game at the blackjack table, in which you are putting your money down and simply hoping for the right card and thus the right payout.

There are numerous cases in which investors have lost money because they just didn’t do their homework. They bought a sales pitch and, to use an old analogy, didn’t look under the cover of the wagon to see exactly how the snake oil was made. Or, they followed a trend of their friends and associates, believing that if so many were investing, “it must be good.”

When it comes to mergers and acquisitions, the term is usually “due diligence”—meaning an investigation of a target investment of one sort or another to judge its soundness.

This same term could be applied to an individual investor as well; however it really boils down to just using common sense and doing one’s homework. Yes, it requires some effort. But then, so did making the money in the first place. One should at least be as industrious when investing funds as one was in earning them.

There are entire books written on the types of factors to take into account on an investment. First might be its record of profits, earnings and dividends paid—but that is merely the surface. How long has that company been in business? What is its record in the type of industry its in? How does that industry play in various conditions of economy, especially in the current one? How much debt has the company accumulated and how do its liabilities stack up against potential earnings?

This kind of information is available in the company’s prospectus, presented to you as a potential investor. While it may make for dry and lengthy reading, you have only yourself to blame if you skip over this vital step, turn over your money, and lose it down the line. You can obtain help in interpreting the prospectus from others, such as your accountant or your broker—who has a vested interest in your understanding of it.

The bottom line is, don’t base a purchase of shares on one person's advice, or upon media rumor or prediction, or even upon the predictions of a single favorite analyst. To do so is basically gambling.

Everything you need to know is right there in the prospectus for you to read. There are many ways to inform yourself before you invest your hard-earned dollars—do your homework thoroughly before you invest.