The Test of a Good Investment

I've always said that the test of a good investment is not how well you do in good times but rather how well you do in bad times. And there is no better time then now to make sense of this little theory.

You see, when times are good everything goes up. Take a look at the technology sector. When the NASDAQ was rising to record levels, it did not take a rocket scientist to pick winning technology stocks – everything made money. Some made more than others did but double-digit returns were pretty much the norm.

I met an investor in 1999 who told me that investing was easy. He did not need a mutual fund manager. He had developed a sure-fire system to pick winning technology stocks. I asked him what his track record was in 1999 and he told me he made about 75% with his sure-fire system.

A 75% return is pretty good by any standards but it is important to understand that the “NASQAQ returned 93.2% in 1999, the average Science and Technology mutual fund returned 78.7% and the median for all Science and Technology funds was 90.8%.

In 1999, it was a record year for new stock issues (IPO) and small technology stocks. Companies with a good story could find investors with big eyes and big dreams hoping for the next big payoff. The market was characterized as EUPHORIC. Even companies with little to no profits could attract investment dollars. We have heard it time and time again “technology is the way of the future” and “how can you go wrong with technology”.

A little different story

In the year 2000, NASDAQ and the technology sector were not so euphoric.

Disappointments in the earnings of technology companies were the catalyst to stock price pressures. Every company whether it had earnings or not, was been hit hard. Given time, technology is a solid long term play at it is the way of the future. In the short term, it will be quality that comes back up. Companies with no earnings will stay down while companies that can show profits and earnings will rebound in time. It is, again, the fundamentals like profitability that shine when markets are tough. When markets are good, we often forget about fundamentals.

There are some lessons to every story and here, there is no exception to the rule. Remember these lessons the next time you hear a good story.

  1. What goes up the most can come down the most. Even though technology was and will continue to be the way of the future, it is important that investments which provide the best returns in good times can also provide the worst returns in bad times.
  2. If it is too good to be true, it probably is. Groucho Marx said it best. Risk and return go hand in hand. If you think you can earn the highest returns with no risk, think again. Investing is a tradeoff and you must determine your sacrifices.
  3. Good research leads to good decisions. Investing has always been premised on research. The more research you do, the more likely you are to be happy with the investment. It is amazing how a little common sense goes a long way.
  4. Look for quality. Often investors look for the best performing investment, but there is very little correlation that last year's best performing investment will be this year's best performing investment. The trick to good research is to try to determine standards of quality.
  5. Diversify your holdings. The investors taking the biggest hit are those investors with too much technology. In fact, the investments that are doing well in this market environment are ‘old-style' investments like financial and resources. Make sure you diversify by sector, asset and geography.
  6. Technology and mutual funds. If you are looking to technology as a buy, be very careful. Not all technology stocks will rebound just because they went down. One of the best ways to buy technology is to look for mutual funds with proven management.
  7. Don't try to time the markets. Although many experts felt the technology market was over-priced, nobody knew when the market would correct itself. In fact, I thought the tech market was over-priced long ago but market timing would have caused me to get out far too early and I would have missed out on big returns.

So, as you prepare to make investment decisions for your RRSP dollars this year, it has never been a better time to take a look at basic fundamentals using common sense. Look for quality and make sure you do some homework or get the help from someone who is willing to do the homework for you.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

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