Trying to make sense of the stock market is no easy task, and even experienced investors often get it wrong. For those starting out in their investment journey, the sheer amount of information available on trading and markets can be overwhelming, even more so when often the information appears to be extraordinarily contradictory. That’s why I have put together my five golden rules of investing to help you to make an informed decision about your investments.
Also see: Guide to Low Risk Investments
It is quite easy to make mistakes, especially if you are just starting to trade, but even experienced investors can slip up and make common mistakes when trading. Mistakes can happen for a variety of reasons, but in order to help you avoid falling into a pitfall when investing, I have put together these few simple rules to help you make informed decisions about your investments.
These tips are not a definitive guide and are not meant to be “the” way for you to invest. Rather, think of them as being guidelines designed to serve as reference points for any investment decisions you may make. At worst they can help you mitigate and avoid risk and, at best, they can set you on the right path towards making healthy returns.
Many investors develop their own rules and strategies based on their own experiences over time, which is a luxury that many smaller and part-time investors whose own capital is tied up in investments simply do not have. As such, in order to increase your own chances of success, it can be useful to read around and learn from these old hands. That way you are not only ensuring you are an educated investor but also avoiding putting yourself in potentially dangerous positions that could end up costing you money.
So, whether you’re a novice investor still making your first few tentative steps into the market or you’re a veteran checking that you’re on the right track, read these five golden rules of investing.
1. It’s time in the market, not timing the market
It’s an old truism and one that you should always bear in mind, but remember, namely “it’s time in the market, not timing the market”. In other words, the secret behind the success of many famous investors is that rather than trying to time the market, they focus on time in the market and take a long-term position.
Often new investors think that the best way to get great returns on investment is by trying to predict market developments and then, based on this knowledge, to buy and sell accordingly. This is a mistake made by many, and proof positive that a little knowledge is a dangerous thing as new investors like to think they have a strategy or unique insight that will help them tame the chaos.
The trouble is that no one can predict the future, and anybody that says otherwise is likely trying to sell you something. As such, if you’re basing your investment decisions on what you think might happen in the markets over a short period, it is a strategy that will almost certainly end up costing you.
Instead, it’s often best to focus on a longer horizon for your investments. Rather than trying to capitalize on rises and falls, it can be sensible to generate slow, steady returns by investing in the market for a prolonged period. In fact, according to research by investment platform Nutmeg, investors who held stocks in the market between 1971 and 2020 never lost money if they invested for 13 and a half years or more. In fact, if one looks at the growth of the S&P500 since March 2009, it has grown at a rate of 271%, and that’s with short-term shocks such as the election of Donald Trump, the UK’s Brexit referendum, and the EU meltdown of 2011.
Using a robo-advisor
For those that are unsure of how to design an investment portfolio, or for those who know that they don’t know enough, then it may be smart to make use of a robo-advisor to help create a long-term investment portfolio.
A robo-advisor is a great tool that can help you to automatically set up—and manage on your behalf—a range of portfolios, and select stocks and strategies that are in line with your investment goals. The robo-advisor makes its decisions based on a number of surveys and questionnaires that you will be asked to fill in when you first sign up for the service. By doing so, you are essentially handing over the day-to-day management of your account and doing away with the stress of actively managing your account, in essence, leaving you free to sit back and let your invested funds grow over time in the background.
You can read my guide to the best robo-advisor platforms to find out more about robo-advisors and whether they’d be a good option for you.
Experts often recommend an investing horizon of at least five years. That way, you’ll give your investment sufficient time in the market to start generating returns.
2. Don’t put all your eggs in one basket
The second golden rule of investing is to ensure you minimize risk exposure by spreading investments out. In other words, don’t put all your eggs in one basket. This investing concept is also known as “diversification”. Diversification helps to ensure that you’re not overly invested in one area, and as such helps minimize losses in case of a crash in an industry or sector. For example, if you had stock in the hospitality sector during the Covid crisis, their value would have fallen markedly but this fall would have been offset by any investments you may have held in the pharmaceutical sector. This is an important strategy and one you should always bear in mind because, if you held all your money in one company and its value fell, your entire portfolio would fall with it.
Instead, it’s often a good idea to spread your money out across different regions, sectors, and asset classes. A good rule of thumb to follow here is the “5% rule”, in which no more than 5% of your entire portfolio is invested in one company, sector, or area.
Choosing investments across different countries and regions can help to avoid your investments being affected by specific economic or political changes. For example, investments in other countries and regions will be subject to different pressures than US stocks. So, if your US investments all fell because of specific localized circumstances, for example, drought or other adverse local factors, your investments in other countries might not.
Sectors and industries
As well as other locations, it can also be sensible to consider different sectors and industries. For example, the pressures faced by a petrol company are different to those faced by a company specializing in renewable energy. By investing across different sectors, you are helping to lower the chances of all your stocks losing value at once.
Another way to diversify your portfolio is to consider your asset allocation. An asset class simply refers to the type of asset that you’re buying. There are many different asset classes you might consider, but common ones to consider spreading your money out in are:
- Stocks and shares in companies
- Bonds, including corporate and treasury bonds
- Commodities, such as gold and silver
- Real estate, whether that’s physical property or through real estate investment trusts (REITs)
Holding a range of different assets can further help to spread out risk.
3. Dividend-paying stocks can be transformative
A good idea in general, and the third rule on our top five list, is to invest in dividend-paying stocks and shares. Dividends are payments made by companies to their shareholders, these payments are usually paid out on a quarterly basis. These payments are a sort of thank-you from the company to their shareholders for holding their shares. These are typically paid out as a portion of profits, reflecting a company’s performance in a certain period.
Dividends can be useful as they offer you the chance to earn an extra passive income from your investment, even if the stock you’re holding hasn’t risen in value. You can then take these dividends as profits or reinvest them in more stocks and shares, further boosting your holdings without having to invest any more of your cash.
Over time, dividends can really add up, giving you an alternative source of income in your portfolio. Consider including some dividend-paying companies so that you can add this extra quiver to your portfolio’s bow.
4. Steer clear of the hype and the herd
My fourth rule is an incredibly important one, but also one that can be difficult to follow. This is to steer clear of investment hype and to avoid following the herd.
Think of the GameStop short from the start of 2021. Many investors piled into this opportunity as it become popular, with the gaming shop’s share price rising to remarkable highs of nearly $350 a share. Unfortunately, many of the individuals who then bought this share arrived too late, ultimately losing out as early investors sold their holdings, the meme lost traction, and the price quickly fell.
Be wary of following the herd; oftentimes it is wrong. But even if it’s not, by the time the herd becomes a stampede and starts making waves, it’s far too late for stragglers to jump on to try to make a profit. If you’re considering an investment that’s become popular in this way, make sure you do your own research first so that you know whether it’s a worthwhile opportunity for you.
Be an iconoclast
Instead, rather than following the herd, you should not be afraid to go against the flow. Warren Buffett, a titan of the investment and financial services world, once said that investors should be “fearful when others are greedy, and greedy when others are fearful.”
What Buffett was saying is that smart investors are those who avoid the herd and find investments that others aren’t targeting, looking to capitalize on market movements before they even happen.
Buying what you understand
Warren Buffett, aka the sage of Omaha, also advised investors to only buy what they understand. In other words, avoid being too clever or jumping onto hype-trains you only fleetingly understand and only make investments in sectors that you have an understanding of.
It may be useful to think of the recent GameStop short. There was no doubt potential to make money here, but many people who didn’t understand the concept of “shorting” a stock may have ended up losing money as they lacked the knowledge and tools to manage the situation properly.
Another recent example is the Pokémon craze, which saw prices of the original 90’s trading card game rocket in the early days of the coronavirus pandemic. This was thanks to a unique combination of events occurring at the same time: high-profile YouTubers such as Logan Paul putting a spotlight on the game, the coronavirus lockdowns creating a marked rise in free time, and a generation who grew up playing the game reaching adulthood. Since then though, the market has fallen off markedly and some cards are down by 25%. The fact is that bandwagons are usually bad news, especially when it comes to investing.
Always make sure you do your own research and know exactly what it is that you’re buying. That way, you’re more likely to know how to manage your investment.
5. Never invest more than you can afford to lose
As I’m sure you know, investing is a risky business. That’s why my fifth, and perhaps the most important rule, is to never invest more than you can afford to lose.
The consensus, based on years of experience and hard data, is that investing for the long term is the best way of ensuring returns. That said, there’s simply no way of predicting exactly what will happen in the stock market, and you have to be mentally and financially prepared for the fact that you may not come out with a profit. That’s why you should only invest money that you can afford to lose.
Never invest money that you need for living your daily life, such as paying bills, and be willing to accept that you may lose your entire investment.
Keeping an emergency fund
If you’re concerned that you’ll end up putting too much of your money in the market, a good way to avoid this is to set up an emergency fund.
Ideally this fund should have enough money in it to help cover your usual expenses for a period of at least six months. This is a useful fund to have, not just for those investing in the stock market, as it helps cover any unforeseen situation and helps keep you and your family safe in the event of the unexpected.
You should keep this money in an easy-access savings account so that you can get to it quickly in the event that you need to.
Bonus rule: set your investment strategy to your goals
While the five tips I’ve already given you are my main golden rules for investing, I would like to also leave you with this extra piece of useful advice: align your investments with your financial goals.
Whether you are starting your investment journey in order to help buy a new home, or you’re trying to build a nest egg for the future, always invest with your goals in mind. That way, you can tailor your investments and ensure that they are all working toward reaching the same goal.
Taking financial advice
If you need help designing a portfolio that’s aligned with your wider financial goals, you may want to consider taking advice from a professional planner or advisor. Financial planners and wealth advisors have the tools to help provide you with personalized information on the investment products and assets that are right for you and your goals—and will help you build a diversified portfolio that suits your needs.
They can help show you where you might be taking on too much risk and provide suggestions as to where you could refine and improve your strategy so that your investments are as efficient as possible.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of, and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.
Investing Frequently Asked Questions
What are the five golden rules of investing?
The five golden rules of investing are:
1. It’s time in the market, not timing the market.
2. Don’t put all your eggs in one basket and diversify your investments.
3. Dividends can be transformative.
4. Steer clear of the hype.
5. Never invest more than you can afford to lose.
What is the 5 percent rule in investing?
The 5 percent rule in investing is that investors should invest no more than 5% of their total portfolio in a single investment. This rule is designed to encourage diversification so that investors do not end up overly exposed in one position.