When Analyzing an Investment, What are the Underlying Economic Principles that Make it Work?

by Wes Bridel on February 8, 2010

in Stewardship

Don't jump into an investment just because it sounds excitng if you are buying above the true value of the investment.

Don't jump into an investment just because it sounds exciting if you are buying above the true value of the investment.

Every investment opportunity, financial product, or business opportunity must take advantage of economic principles to be successful.  It’s important for you to understand what these are so you have a basis for knowing the dynamics  involved in bringing success to your overall financial planning.

Whether you’re looking at a real estate, stock, bond, gold, silver, hard money, or any other investment, you should understand the principles you expect to be at work to bring profit.  We won’t attempt to list all economic principles here, but we’ll list a few as well as give examples as to how these might be at play within a particular investment.

A) Purchasing below true value – Understanding the real value of an investment is always important when placing your hard earned money on the line.  Just because an investment idea sounds exciting, that’s no reason to jump in if you are buying above the true value of the investment.  On the other hand, a great investment could very easily involve the most boring asset in the world if you’ve determined that you can purchase it at far below its true value.  This is what Warren Buffet and many other of the world’s best investors have made a living doing. We’ll talk more about how to do this when we speak about particular types of assets.

Several examples of this would be purchasing:

  1. A rental house at much less than comparable houses in the neighborhood are selling for and can reasonably be expected to be sold for into the future expected holding period.
  2. A stock considerably below its book value.
  3. A closed-end mutual fund selling below its Net Asset Value.
  4. A bond selling far below par (face) value.

B) Leverage – This is the art of using something outside yourself to maximize your potential within an investment.  It is always a double edged sword so while it can multiply your profits, it also has the potential to make a small loss huge.

Tomorrow, we’ll talk about different forms of leverage.

This is Part 2 sin the series Investment Due Diligence. To continue with this series, click on Pt 3. To use this as a growth tool to better understand your own calling, you might start by reading Part 1.

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