Investment is a challenging task, and most individuals invest in assets that they don't understand and well-informed they are. Some of them follow the recommendations given by friends or social media influencers when they make investment decisions. Others make investment decisions based on their beliefs and reasonings developed with insufficient information. Investing in an asset that you don't understand is one of the most severe mistakes since you carry the risks you are unaware of and may have losses that you could avoid.
As an informed investor, you should be able to answer the following questions before you invest in an asset:
• What are the features of the asset? Do these features provide an advantage? For instance, if the bond you invest in is a senior secured bond, the recovery rate would be higher in case of bankruptcy. Therefore, a junior unsecured bond issued by the same borrower would have a higher yield to maturity since it has a higher risk. An uninformed investor might think that the junior unsecured bond issued by the same borrower and paying a higher return is a better investment. The investors need to know the merits of the securities to compare and select the one to invest among alternatives.
• What are the sources of risk and return? To make successful investments, you need to understand the factors that would affect the income generated by the security. You can access information about the economic environment and the alternative investment assets by studying the annual shareholder's reports, following financial news sources, and analyzing the market data. By doing so, you can estimate the opportunity cost of your investment vehicle and forecast its future performance to decide whether it is a good investment opportunity.
• Does the security you want to invest in fit your investment goals? Each investor has a different investment plan with varying objectives. Some investors might want to save for short-term goals, such as buying a new car and quitting their job to learn new skills, such as programming, to change their careers. Other investors might want to save for long-term goals, such as retirement or saving for their children's university tuition. Investors also have different risk appetites. If you are a conservative investor, who doesn't like taking risks, you might not feel comfortable investing in growth company stocks or cryptocurrencies. You should invest in assets that fit your financial goals and risk appetite.
The reason why following the recommendations of others, such as friends or social media influencers, might not work is that their financial plans and risk appetite might be different than yours. Even if they are successful investors who can time the market and figure out mispriced assets, as most of them claim, their investment strategies might be too risky for you. Without a doubt, it is also possible that they might have been lucky in their last few trades since market timing is tricky if you don't have a crystal ball.
Being an informed investor doesn't ensure certain gains. Financial securities are risky, and their returns are dependent on numerous systematic and unsystematic factors. Being an informed investor wouldn't enable you to foresee these idiosyncratic shocks. However, it would prevent unnecessary losses and let you use more sophisticated strategies and securities, which an uninformed investor will not be aware of.
Prof. Dr. Cenktan Özyıldırım
References:
• Questions for Informed Investors, State of Connecticut Department of Banking
https://portal.ct.gov/DOB/Consumer/Consumer-Education/Questions-for-Informed-Investors