If you’re like me, you may know at least one person who made thousands of dollars in just a few weeks by investing in Bitcoin. You may even have thought of putting some money into it yourself. You’re worried it’s a bubble that Warren Buffett says won’t end well, but you also have FOMO. This got me thinking about what successful investors do in general when deciding what to invest in and how to make a rational decision as opposed to being caught up in a herd mentality. Here are questions to ask before investing your hard-earned dollars in the latest investment trend (or fad):
Do you have the money to risk? It goes without saying that unless an investment is guaranteed, there is a chance of losing at least some of the money you invest. That may be okay if you have time for your savings to recover but not if you need the money today. Make sure that you have an emergency fund in place before you invest anything.
Are you contributing enough to your retirement plan to get your full employer match? If your employer is going to match some of your contributions dollar-for-dollar, that is a 100% return on your money. Even a $.50 match is still a 50% return.
Do you have high interest debt? When you consider that a penny saved is a penny earned, it’s hard to beat the guaranteed savings of paying down high interest debt like credit cards. After all, if you invest in the latest craze, you have the possibility of earning a big return or a big loss. If you pay down a credit card balance with an interest rate of 29.99%, you definitely save 29.99% in interest. My rule of thumb is to pay down debts with interest rates of more than 4-6% once you’ve received your employer match.
Are you planning to a buy a home in the next few years? Buying a home is expensive. Not only do you typically need to come up with a down payment of ideally 20% of the purchase price, you’ll also need money for closing costs, moving costs, furnishings and any renovations you do while preserving your emergency fund so you can cover maintenance and the mortgage payment if you’re in between jobs. You’ll want to keep the savings for all this safe or risk having to postpone the home purchase if your investments don’t do well.
Do you understand what your investment is? It doesn’t matter whether it is a stock, bond, gold bullion or a cryptocurrency, be careful of investing in something you don’t understand. Make sure you know the potential risks, returns, and costs involved and how it would fit into your overall investment strategy. If it’s something you’ve never heard of, check sites like sec.gov to be aware of any investment scams that may be out there.
What is driving the investment decision? Don’t fall prey to rationalizing your way into buying something based on emotion. Is there a legitimate reason why you are considering the investment (it has a high risk-adjusted expected return or diversifies your portfolio) or are you simply being swept up in the herd? Ask yourself if it’s really an investment that produces value or a speculative bet that someone will pay more for it than you did when you want to sell.
This doesn’t mean you should never take a gamble. Just make sure that you’re aware of the odds and are only risking money you can afford to lose (not your entire retirement nest egg or your kids’ college fund). This brings us to…
How much do you currently have in it? If you’ve done all the previous steps, it can be tempting to think that you’ve thought through everything, but even the smartest investors make mistakes. The important thing is to not allow any mistake to become too costly. You generally don’t want to have more than 10-15% of your portfolio in any one investment no matter how promising it may look.
Finally, what is your exit strategy? In other words, when would you sell? For example, you can set up a rule for yourself that if your investment loses x%, you sell. You can also do this on the profit side by setting a point where once your investment return is positive by x%, you sell. They key is to take the emotion out of it.
So applying this methodology, how would you assess investing in Bitcoin? Is it a smart investment or a more modern version of the Dutch Tulip? If you’re still not sure, here are some words of “wisdom.”