Top 5 Questions that the “Smart Money” Always Asks Before Making an Investment (That the “Dumb Money” Does Not!)

by kungfugirl on October 19, 2011

Air Yoda!

Let’s get our Jedi Kung Fu on today!!!

Do you ever wonder how some people seem to be able to make money off of just about any investment, while others suffer enormous losses?

Well, today I’d like to share with you 5 key¬†questions that the “smart money” always asks before making an investment:

1. Will I get my money back?

This probably seems idiotic at first glance, but it’s vitally important, and most “dumb money” never thinks to ask this.

The “smart money”, on the other hand, ALWAYS wants to know what their realistic likelihood is of getting their money back (the return OF their capital), and they will not purchase an investment unless they consider this likelihood to be extremely high.

You may have heard Warren Buffett’s famous rules of investing:

Rule #1: Don’t Lose Money, and

Rule #2: See Rule #1….

The smart money knows that in order to actually MAKE any money, they first need to ensure that they will not LOSE any money.

And *if* the smart money does think that there is a substantial chance of losing money, he or she will either not purchase the investment in the first place or will make sure to use insurance techniques such as trailing stops and/or selling puts/calls to mitigate any potential downside.

2. WHEN will I get my money back?

The smart money also wants to know how SOON they will get their money back. Do they need to tie it up for a week, a month, a year, many years? Smart money always wants their money back as quickly as possible so that they can deploy it on another productive investment. They aim to keep their money constantly moving and working for them– something they call “the velocity of money”.

(As an aside, this is why many “smart money” investors do NOT rely on a 401(k) or other type of “retirement” account– it violates this question. In retirement accounts, you are giving up control of your money for years and years (depending on your age), and your control over question #1 (getting your original investment back) is limited. But I will leave the larger issue of retirement accounts for a future blog post…for now, just ask yourself whether Warren Buffet, Donald Trump, the late Steve Jobs, Bill Gates, Jamie Dimon, or any other very wealthy person you can think of uses a 401(k) to obtain or maintain their wealth.)

In addition, ideally the smart money wants to get their money back as soon as possible AND still own the investment. Huh? But how does THAT work?

Well, as an example using the stock market, let’s say the smart money invests in 100 shares of stock, expecting that the stock will double in price. When the stock does double (if it does), the smart money then sells half of their investment (50 shares of stock) so that they are in effect “playing with the house’s money”. They now have received their initial investment money back safe and sound, as they desire in question #1 above, and they still own 50 shares of the stock, which may continue to appreciate. Their risk is now effectively zero, and if the stock drops they still retain their original investment.

3. How MUCH do I reasonably expect to earn on this investment?

Smart money will carefully consider this and decide if the expected reward is worth the risk they must take to purchase the investment. They also use position sizes to speculate intelligently if the reward is very high but the risk is high, too. They do not simply divide their portfolio into 10 equal “chunks” and allocate it equally to 10 different investments; instead, they size up all of the information we discussed above and determine exactly what their position size for a particular investment should be.

4. How liquid is this investment?

(or, “How easy is it for me to get my money out when I need it?”). The smart money always wants to know this– they do not want “trapped, unproductive” capital (like we discussed yesterday), but want to be able to access their money quickly (or have a very high expected return/reward if they do decide to invest in illiquid assets).

5. How is this investment taxed?

Smart money knows that taxes can affect their returns tremendously, and that some investments (like oil and gas LP’s, income-producing real estate, etc.) are tax-advantaged and some investments (gold, silver, and other “collectibles”, savings interest, etc.) are not.

And finally, the Kung Fu Finance Bonus Question…

How Well Will I Sleep At Night?

As I mentioned in a previous article, sleep is one of my most favorite things in life and is very important to me! And while I can’t guarantee you that the “smart money” always asks themselves this question, I know I sure do, and it’s a great way to tell if you have too much invested in a particular investment.

For example, as I mention in yet-another-previous-article,¬†over the past several years I’ve bought quite a bit of silver bullion. However, whenever I caught myself fanatically checking the price more than once per day or wondering at night “what will happen tomorrow?!” (it’s an extremely volatile market), I sold some until I was down to the level where I immediately started sleeping better at night. And that, as they say, is priceless! (To me, anyway!)

So what do you think? How do YOU invest? Have any questions that I missed? Let me know in the blog comments!

To your financial success,

– Kung Fu Girl

 

 

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About the Author:

Susan Fujii, aka , is an SEC Accredited Investor who believes that anyone can learn to be financially independent.

Susan has authored 199 posts on Kung Fu Finance, and you can connect with her on .

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