Photo Credit: Leo Reynolds
I would like to draw some commonalities between the considerations that one makes when he lends money and when he invests. As the former is something most people have encountered and are familiar, I hope you would be able to draw the relations and aid you in making better investing decisions.
So what do you go through in your mind when you lend money to others?
The first question you will ask yourself is that do you trust the borrower to pay you back as promised? Let us assume that you charge an interest to the borrower. How sure are you that you will get both your capital and interest back? I believe here are some of the factors you will consider:
Understanding the background
Would you lend money to a someone you do not even know? Would you invest in a company without a good understanding? I believe the former you wouldn’t but people do commit the latter as they listen to their friends and relatives that the company stock is worth buying. If your friends and relatives recommend borrowers to you who pays you interest, will you lend money to them? I believe you will want to find out more. So find out more about the company before you invest!
Analysing the history of debts and the purpose
You will also like to find out whether the borrower has been borrowing from others at the same time. You do naturally do not trust someone who keeps borrowing and accumulates debts such that he/she is not able to pay you back. That is why banks look at your current debts and liabilities as one of the considerations to approve any loan to you. Likewise for investing, you want to find out the financial health of the company. How is her debt ratio to assets and earnings? Is the company in high debts such that it will have to channel her earnings to repay them? If she has taken a debt recently, what is she using it for? Is it constructive, for example, using the funds to expand her business or researching new products?
Looking at the source of income
If the borrower has no source of income currently or in the near future, will you still lend him/her? Banks look at your personal income before deciding how much they are willing to lend you. You will not be able to apply for a credit card if you do not have an income. Hence, relating it to investing, you need to find out the earnings of the company. Is the projected earnings enough to manage the debts and still able to pay good dividends, and increase her shares price due to the growth in the business?
Do not expect immediate return
When you lend money to someone, you would want him/her to commit a date to pay you back. If he/she promises a month later, you do not look for him/her the next day to pay you back. You do not expect an immediate returns to your investment. Although there is no fixed date that the investment will provide you the gains, the idea of a time lag is similar. Thus, do not invest money that you would need because you do not know want to cash in your investment at a loss.
No 100% certainty
Even if you lend money to your best buddy, you cannot be 100% certain that he/she will return you. That is the risk you have to accept. In investing, no matter how sure you are that the stock you pick is a winner, you must accept that it can still go against you.
I must say clarify that the factors to consider are not exhaustive but they do provide good measures to ensure your investment would be sound. These are rather basic questions to address before you part your money in any investment.
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