David French | 18/02/2009 4:05:39 PM

This article was originally published as “Seeking investments? Get to know your limits” in The Morning Bulletin in October 2001

There are two ways to choose an investment. One is to do what you are told and the other is to do at least some of the work yourself. The former enables you to blame someone else if it goes wrong, but that is small consolation ‘cause you lost your money anyway. The latter means that you take some responsibility for what happens to your money, and combined with some professional advice that will lead to a much better result.

You don’t need to have all the financial skills to invest successfully, a good financial professional has those. You do need to know the nature of the investments that you are getting into and have an idea whether they suit you. For instance need to decide whether you are prepared to whether the volatility of shares (or managed funds investing in shares), or if you would prefer a more tranquil place to put your money.

What can an individual do to get more acquainted with investment choices? First read any material that you are given. Research and prospectuses are valuable sources of information. That will give you at least an overview. Things to look out for include the price of the asset, what the investment does and whether it is well managed and the financials are sound.

Price is about how much you pay to get a certain dollar return. Price earnings ratios and dividend yield are very common. The higher the P/E ratio the higher the price, and the lower the yield the higher the price. An investment with a price of $10.00 and earnings per share of $1.00 has a P/E of 10. There is no difference between that stock and one costing $100.00 with earnings per share of $10.00. The same sort of logic goes for yield – you could say that a term deposit with a 3 per cent yield is dear, but one with a 6 per cent yield is cheap. If someone says an investment with a price of $100, don’t say “boy that’s expensive”, ask what the P/E ratio or the yield. If the P/E is high then you need to ask some searching questions about value for money.

What does the investment do? Some people have invested in a company that looks for treasure off South Australia. We’d all like to find a treasure chest, but would you actually pay someone to look for one? But a company that sold everyday staples like say Woolies – well it might or might not be a good investment, but at least its main activity is plausible.

Whether a stock, a commercial property or a managed fund, management makes or breaks all investments. Are the senior people well known, what is their track record? The board sets direction for most investments. Is the board vibrant and knowledgeable or just an old boys club? Are there a lot of related party transactions in the company accounts. Get worried if Bill Bloggs service station owner shows up on the board of some Biotech company. These things give clues as to the people who are expected to grow your investment.

Are the financials sound? High levels of debt are inappropriate for cyclical companies, but may be OK for companies with high and stable cash flows. Forecasts of profits that double each year are almost always spurious. Are the assets in the balance sheet of good quality. Lots of goodwill, intellectual property, brandnames or other intangible assets often spells trouble.

Above all make the end decision yourself. If you are not comfortable then say no.

The Investment Collective (AFSL 471728) is a non-aligned financial planning and investment firm specialising in providing tailored financial and investment advice for individuals and small business. Capricorn Investment Partners Limited's services include financial planning, share trading, portfolio management, insurance broking and self managed super fund administration. Additional information on services provided by The Investment Collective Limited can be found by following this link. Readers are reminded that this document has been prepared for general information purposes only, and any advice contained herein has been prepared without taking into account your financial objectives, situation or needs. Readers are advised to see their financial advisor prior to acting on any general advice.

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