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Ten good rules-of-thumb for investing
Saturday, 15 April 2006
I've been investing money for about 14 years now and have had more success than failure along the way. I've also read a large number of books and articles on good investment strategy. Here are my rules-of-thumb if you want to get ahead in the money game.
Realize that all investment is risk
Whenever you put money aside for investment rather than immediate use, what you're doing is delaying consumption. You're hoping that by not spending money on your wants today, you'll generate more to spend on your wants tomorrow.
However, there's no such thing as a perfectly safe place to put savings. All investment involves the risk that you will never see your money again. The rules I lay out here should reduce that risk, but realize that there are no guarantees. Also, keep in mind the most basic law of investment which is - increased return equals increased risk.
Be conservative
Many new investors, including myself at the time, see investment as an easy path to quick riches. They throw their money into whatever asset is popular with the financial press, without really thinking about it too much, and then sit back waiting for the cash to roll in. Needless to say, they are usually disappointed.
Good investment is usually a slow process, with small gains in the short-term adding up to big gains over the long-term. It's fine to set aside part of your money to speculate on big short-term gains if that's what excites you, but be conservative with the majority of your funds.
Don't chase big capital gains
Most amateur investors think they see the core concept of the investment game straight away - capital gains.
It's true that the increasing value of your investment, as compared to the income that investment generates, can often be where most profits lie. However, one thing that history teaches us is this - big capital gains are extremely hard to predict.
Almost all speculative booms are built on the rush for what appears like certain capital gain. Most of those who participate in such booms, especially during the later stages when the capital gain is most anticipated, often lose their money.
Try to ignore the promise of big capital gains. It may be worthwhile to not think about capital gain at all. Follow the other rules-of-thumb in this article, and you'll probably get gains that more than compensate you for your risk.
Look for investments that generate income profits
The type of investment you want is one that gives you a profit even without capital-gain. Quite simply, you want to own a piece of something that's got more money coming into it than going out of it. Look for a good positive revenue minus expenses.
If you are investing in shares, the price-to-earnings ratio is a good simple way of measuring this. Don't worry too much about dividends (unless you need the cash) because a well-run business that reinvests money in itself is likely to generate even bigger profits in the future.
If you are investing in real-estate, you can work this out by looking at what a property is likely to attract in yearly rental, minus the costs of owning that property such as council taxes and maintenance.
Compare potential investment returns to what you could get almost risk-free
All investment is risk, but some things are less risky than others. The most risk-free investment of all is government debt and particularly US-government debt.
It would take something extraordinary for a developed country's government not to be able to repay its debt. Something so extraordinary that all other investments in that country would probably be rendered worthless in the process.
If a government bond is paying 6% a year, you would be crazy to accept anything equal to or less than that from any other investment. In order to take on more risk, by investing in say shares or property, you need to be compensated by getting better returns.
If you're a fairly passive investor who doesn't want to spend too much time buying and selling bonds, you can use another fairly low-risk investment as a substitute for this measure. Look at savings accounts at reputable banks. While such accounts are by no means risk-free, they are probably more so than most other types of investment. If your local bank is offering 7% on deposits, you should expect more than that before tying up your money in more speculative ventures.
Keep transaction costs to a minimum
Whenever you move money around there's always someone with their hand in your pocket - the middlemen and advisors. Keep a sharp eye on any entry, exit or ongoing fees when you invest.
If a financial advisor takes 5% commission for any money he invests for you, that's 5% you have to make up before you even get started. If a mutual fund charges 2% a year to manage your money, that subtracts 2% from your potential annual gains. If a real-estate agent charges you 10% to sell your house, that's a big chunk out of any gain. If the government puts an 8% tax on any sale of your business, you can kiss at least a year's capital gain good-bye.
Take into account the transaction costs on any investment decision you make and cut them to the bone. Be very sceptical of any promise that higher transaction costs will lead to higher returns.
Always have inflation and tax in mind
As an extension to the previous point, you should always be thinking about what effect inflation and tax are going to have on your returns. If the inflation rate is 3%, then you have to generate at least that amount every year just to maintain the purchasing-power of your capital. In other words, a 3% return in such an environment is really equivalent to a 0% return.
The same holds true for tax. If the government is going to grab half of anything you make, then you should note this before making any decision.
Keep your activity to a minimum
When most people think of rich investors, they think of someone extremely active yelling "buy" and "sell" into the phone. In fact, smart investors are relatively inactive. Once you have decided to put your money somewhere, you should stick with it unless there's an extremely good reason to do otherwise. Every time you shift your cash, you lose some of it through transaction costs. Worse, active investment is often driven by emotion, leading you to buy when prices are going up and sell when they're going down. Try to ignore the inevitable ups and downs of the market.
Spread your risk over assets and time
For most people, spreading your risk is good advice. Focussed investment can generate higher returns, but it takes a lot of work and extra risk. Generally, the majority of investors shouldn't have their eggs in one basket. A mix of cash, property, and shares with about the same amount placed in each is a good strategy. Also try to spread shares across a number of different industries and property across a number of different locations.
You can also spread your risk over time using what's known as "dollar-cost averaging". What this means is that rather than moving a big chunk of money all at once, you spread out your buying and selling over a longer period. That means you are less likely to sell when the market is at its lowest and buy when it's at its highest.
Always be on the lookout for bargains
Keep an eye on businesses, property, currencies, and stock-markets you know well. Such things move up and down a lot, and sometimes the market can present you with some unbelievable bargains. If you see something that you understand well has fallen in price a lot for no really good reason, it may be time to buy. Just remember that such events are fairly rare. Only take advantage of this when you're sure.
So there they are, my ten investment rules-of-thumb. I hope they help you accumulate riches.
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