Understand the Risk
The link between risk and return is the most fundamental rule of investing.
All investment involves risk. Even a ‘risk free’ government guaranteed bank deposit involves risk: the risk that the return will be insufficient to meet your needs.
And the risks for each investment are different. So every time you contemplate an investment, make sure you understand its individual risks.
If you’re underwhelmed by interest rates and are concerned about the costs of managed funds and property investments, you may be thinking of investing directly in shares. If so, we offer a few guiding principles to help you invest successfully (and relatively stress free).
1. Take your time
Plan to get rich slowly (rather than quickly). If you rush it, you will inevitably go down the path of being a gambler rather than an investor. If you are investing money that you might need some time over the next five years, the market may not be the best place for it. Over longer time periods, however, time smooths out market fluctuations. Long term share investors expect to double their money roughly every ten years and that’s after taking inflation into account.
2. Diversify your investment
Modern portfolio theory proves what your great grandmother knew: it’s very risky to put all your eggs in one basket. One of the best ways to reduce risk is to diversify. Aim, over time, to build up a portfolio of at least a dozen companies (preferably more) across a range of industries.
3. Diversify your timing too
You can also reduce risk by spreading out when you invest. Called ‘dollar cost averaging’ it involves splitting your planned investment into small chunks and spreading purchases out over time (for example, you could invest one sixth of your money every two months to average your investment over a year). This works best if you use an online broker to minimize brokerage costs.
Some investors are more comfortable taking a flexible approach in this regard. If the market is trending down, you could hold off your ‘next tranche’ until the price of your target company seems to have settled. Conversely if the price is trending strongly upward, you could bring forward your next purchase. Remember though: this approach doesn’t reduce risk as much, so set yourself limits and stick to them.
4. Think very carefully before borrowing
Borrowing to invest can produce powerful returns but it turns the risk dial the other way.
5. Don’t panic
Prices go up and down in the short term but if you buy well managed companies, they will weather short term storms. The most important thing is not to panic and sell if the market is weak. If the companies themselves are in good shape they will continue to make profits and pay dividends … and in time the market will come back, so you can and should ignore short term market swings. Sell a share if the outlook for their business has changed rather than because of short term market fluctuations.
6. Reinvest the dividends
We’ve said this before: the real secret to wealth is the amazing power of compound interest (which only works over time) so … reinvest those dividends. Most companies offer dividend reinvestment schemes, which allow you to avoid brokerage costs. An alternate approach is to accumulate dividends from all your investments until you have enough money to invest in another company, increasing diversification to reduce risk.
7. Get the best investment advice you can – then think for yourself – unemotionally.
Talk to friends who invest. Consult a range of professionals. Try to expose yourself to as many different points of view as possible. Then do your own research.
When a group of business-school students asked the most successful long term investor on the planet, Warren Buffett, why so few have been able to replicate his investment success, he replied, “The reason gets down to temperament.”
Investing fortunes are made, not by jumping in and out of shares based on fear and greed, but by buying good businesses and investing in them over the long haul.