5 Investment Rules That You Should Never Forget
Following these cardinal investment rules will help you ensure long-term financial security and success.
Every investor would like to maximise returns while keeping risks under control – but that’s easier said than done. When the market is booming and practically every stock registers large gains, your judgement can get clouded and you may make the wrong investments.
Sooner or later there will be a market correction or even a crash. The value of your shares could plummet. What will you do? Unfortunately, the action that many investors take is not in their best interest. Instead of waiting till prices rebound, they decide to sell at a loss.
As a result, these investors would have bought when the market was at or near its peak and sold at the bottom. That’s a recipe for financial disaster.
This is not the only type of mistake that investors make; there are many others as well.
Here are a few simple rules that could help you to avoid the most common investment errors. If you can put some of them into practice, it may help you to boost your portfolio’s returns over the long haul.
1. A DIVERSIFIED PORTFOLIO IS ESSENTIAL
Don’t make the mistake of deploying all your resources into one type of investment. While it is true that stocks can provide the best long-term returns, it is inadvisable to restrict yourself only to this asset class. A diversified portfolio that includes stocks, bonds, real estate, and commodities will help to strengthen and stabilise your portfolio.
In addition to diversifying your portfolio, you must remember to rebalance it periodically. When stock market valuations rise, it is likely that you will need to liquidate some of your investments in shares and purchase fixed income securities with the proceeds. This will help you to maintain your stock-to-bond ratio.
2. SELL THE LOSERS, LET THE WINNERS RIDE
Peter Lynch is widely regarded as one of the most successful fund managers. After graduating from the Wharton School, he joined Fidelity Investments as an investment analyst. Some years later, he was made the manager of the Magellan Fund.
During his tenure at this fund from 1977 to 1990, it made an average annualised return of over 29%. How did he do it? He believed that the best way to make long-term gains was to identify high-growth companies and hold their shares for extended periods.
Lynch was responsible for coining the term “multibagger stock.” This phrase refers to a share that multiplies many times in value after you buy it. He advised investors to avoid disposing of a share only because it had made large profits for them. Instead, you should remain invested as long as the company has the potential to grow.
He also said that investors should not hesitate to sell a stock if they thought that it did not have good long-term prospects.
3. DON’T TRY AND TIME THE MARKET
New investors often think that they can profit by buying when share prices are depressed and selling when the market reaches a peak. Unfortunately, it’s very difficult, even impossible, to time the market successfully.
How will you know when the market has peaked? It is impossible to tell whether a downtrend in share prices is merely a temporary phenomenon or the start of a bear market. Instead of trying to time the market, you should stay invested for the long-term.
If you have the discipline to remain invested for an extended period, it is likely that you will earn a positive return. In the last 90 years, the S&P 500 has given an annual return of about 9.8%. Of course, that’s an average return and you cannot expect to earn that consistently on a yearly basis.
4. PLAN YOUR CASH REQUIREMENTS
A personal cash flow statement can help you to plan your day-to-day expenses. It also serves another very useful purpose. You can use it to project your future requirements for cash and work out how you will meet them.
Say, you need a lump sum after six months or a year. You may need to arrange the down payment for a residential property or pay your child’s college fees.
This money should be arranged well in advance. Don’t plan to sell some of your stock holdings to fund these requirements when they arise. You don’t know what the stock market will be like after one year or 18 months. If you have to sell your shares when the market is down, you could be forced to do so at a loss.
Instead, you should arrange for the cash and keep it in a bank deposit or a money market fund. This will ensure that you will have the funds when you need them.
5. KEEP YOUR INVESTMENT COSTS UNDER CONTROL
The expenses that you incur when you buy a mutual fund or an exchange-traded fund may seem minor. But they can add up to an unbelievably large amount over an extended period.
Remember that the power of compounding works for your costs as well. If expenses of 2% or your investment amount are deducted on a yearly basis, your total returns can be severely impacted.
This example, provided by the Vanguard Group, one of the world’s largest investment management companies, illustrates the point very well.
An investment of $100,000 that earns a constant return of 6% per year would become $430,000 in 25 years. What if you had to pay 2% in costs every year? How much would you have at the end of 25 years? You may be surprised to learn that instead of $430,000, you would get only $260,000.
THE BOTTOM LINE
The most important rule that investors need to follow is to remember to stay invested when the market crashes. Selling your shares when prices fall is probably the biggest mistake that you can make.
It may be useful to write down your investment plan on a piece of paper. The rules that you intend to follow may seem very sensible when you read about them. But they could be difficult to put into practice.