Investing is one of the best ways to reach your big financial goals like buying a home or retiring. Successful investing depends on having a set of guidelines, or principles, to guide your investment strategy and stay on track towards your goals.
Just as everyone has different investing goals, so too does every investor have different investing principles. In this guide, we’ll explain how to develop your own investing principles and highlight some common guidelines.
What is Investing?
Investing involves putting money into an asset or project that you believe will generate a return over time. It’s one of the best ways to put your money to work for you so that you can build a nest egg and reach your major financial goals.
While many investors equate investing with the stock market, investing is much broader than that. The universe of potential investments includes other tradeable assets like bonds, savings accounts, or even a business. No matter what you’re investing in, it’s important to have a set of principles to guide your investing decisions.
What is an Investing Principle?
An investing principle is a rule or guideline that you can follow when making an investment decision. Whenever you’re choosing investments or creating an investment strategy, you should consult your investing principles to decide how to proceed. Your investing principles should clearly reflect your financial goals and help keep you on track towards them.
Why Do You Need Investing Principles?
Investing principles play two important roles in investing.
First, they help shape your investing strategy. If you’re trying to decide what to invest in or whether a particular investment makes sense, you can look to your investing principles for guidance.
Second, investing principles help you act with purpose and ensure that everything you do moves you one step closer towards reaching your financial goals. Whether you’re weathering a market downturn or taking a risk on an investment, you should consult your investing principles to make sure you always have your long-term goals in mind.
Your Investing Principles
Every investor is different and has different goals and risk tolerances. One person might be investing aggressively to make extra income, while another is investing conservatively for retirement. So, while there are common investing principles out there, no two investors will use exactly the same set of rules for how they invest.
Whatever your investing goals, it’s important that you make your own investing principles that work for you. Use popular investing principles as a guide, but don’t be afraid to tailor them to your needs.
Popular Investing Principles
When developing your own investing principles, it’s a good idea to look at some of the guidelines that many experienced investors use. Here is a selection of popular investing principles to get started.
Have a Plan
One of the essential rules that successful investors follow is to have a plan for every investment. If you’re making an investment, you should have a clear strategy in mind for what happens after you invest. Decide roughly how long you plan to hold, what amount of profit you expect to see, and what amount of drop you’re willing to weather before you sell.
Know Your Risk
Understanding your tolerance for risk is an important part of investing. You need to determine how much of a loss you’re willing to take on any single investment and make sure you never exceed that amount. For example, if you can’t stomach a 20% loss, then plan to sell as soon as an investment drops 10% or 15%.
If you set rules around when to sell a losing investment, make sure to follow through on them. It’s easy to get emotional and hold onto investments while they continue losing money. For stock investing, you can set a stop loss on every trade that will trigger a sale automatically.
Investing early is just as important as investing well. That’s because money you have invested compounds over time. The longer it’s invested, the more you’ll end up with later in life.
To understand the power of compounding, let’s take an example. Say you invest $10,000 at age 30 at a 7% rate of return. At age 60, you’ll have $38,700. However, if you had invested that same $10,000 at age 20, you’d have $76,100 at age 60. Investing early can dramatically boost your financial position down the road.
Alongside investing early, it’s a good idea to invest regularly. This has several benefits. First, you take advantage of compounding by investing repeatedly and often rather than waiting until later. Second, investing regularly builds a habit of saving money and investing it. Finally, investing regularly allows you to take advantage of dollar-cost averaging. You’ll invest in both good times and bad times and end up matching the market’s performance.
To get in the habit of investing regularly, you can set up automatic withdrawals to your brokerage account or set a calendar reminder to invest every month.
Portfolio diversification is a hallmark of smart investing. Diversification in investing means investing in different types of assets across different sectors of the economy.
Diversification is akin to “not putting all of your eggs in one basket.” This allows investors to mitigate risk by having broader exposure to different markets. For example, if your portfolio is invested entirely in tech stocks, your performance will be 100% relative to the performance of the tech industry. This is great when the tech sector is doing well, but less so when the tech sector is underperforming. Diversification, such as adding stocks from different industries, can help you mitigate the risk of being reliant on the performance of one sector.
You might diversify by investing in stocks, bonds, and real estate, or by investing in stocks from distinct market sectors like automobile manufacturers, tech companies, and healthcare companies. You may also diversify within a sector or asset class.
Here are some examples of diversification:
- Diversification of Asset Classes – Mix of stocks, bonds, and real estate investments.
- Diversification of Sectors – Mix of stocks in different sectors like technology, consumer staples, and utilities
- Diversification Within a Sector – Mix of stocks within a sector. For example, in tech, you could buy chip makers, online services, electronics manufacturers, etc.
If you do not know which stocks to include in your diversified portfolio, you can rely on the research of others. For example, Motley Fool Stock Advisor provides two new stock picks every month, as well as a list of 10 starter stocks that can serve a strong foundation for any portfolio (available at a discount for new members).
You can also hedge your investments. If you have a lot invested in the stock market, for example, you could make a big investment in a different asset class like real estate. Or you could keep a stockpile of cash in a high-interest savings account so that you’re ready to jump into the market during the next downturn.
Don’t Try to Time the Market
Many investors try to time the market, but research has shown over and over again that very few people are successful doing this. For that reason, it’s generally better to focus on investing early and often than on trying to time the market. The more time you spend in the market, the more likely you are to match its performance and the more you take advantage of compound interest.
Investing fees can add up quickly, and you might be surprised at how much they can eat into your investing profits. Financial advisors, stock brokers, mutual funds, and ETFs all carry fees that can range up to a few percent of your investment. A 10% annual return is considered excellent, so a fee of 2-3% can be very significant.
Be sure to check what fees are associated with every investment and think carefully about whether those fees are worthwhile.
Ignore the Noise
Investors have to deal with a lot of information, including everything from economic pronouncements to financial news to rumors and advice from other investors. That information can be overwhelming, so it’s important to stay focused on your strategy. Simple ignore or set aside any information that you can’t directly use as part of your investing strategy.
Rethink and Rebalance
Part of what makes investing so exciting is that things change over time. The market goes on a rally or suffers a downturn, or your financial goals shift. When things change, it’s important to stop and think about whether your investing strategy is still suitable. If it’s not, don’t be afraid to adapt it to the new conditions.
Invest for the Long-Term
It’s easy to get sucked into the day-to-day ups and downs of the market. But if you’re investing for financial goals that are years away, these daily fluctuations don’t mean much. Ignore daily price changes and focus on the time horizon that matters to you when investing.
Having a set of investing principles is essential for every investor. These principles can help shape your investing strategy and keep your financial goals in mind as you invest. Use popular investing principles as a foundation, but make sure that the investing principles you choose are specific to your investing approach.