The six golden rules of investing
While I like straight talking, I don’t typically answer the question because the answer is ‘it depends’ – on how long you’re investing for, what you’re saving for, your attitude to risk and your other financial commitments, among other things.
That said, there are some general principles investors can follow if they want the best chance of achieving their financial goals, whether it’s retirement saving, holiday planning or buying flats for the kids.
These principals should help investors separate the noise and deluge of information of the market, from their ultimate goals.
1) Be clear about the length of your investment
A great deal depends on how long you’re investing for. Generally speaking, the longer you’re investing for, the greater risk you can afford to take. If you need regular or imminent access to your savings, it’s better to err on the side of caution.
History shows that shares provide the highest long-term growth but they’re also the riskiest type of investment. Between June 2007 and March 2009 (i.e. the credit crunch), the FTSE 100 fell by over 40% (see table two). It didn’t recover until around May in 2013, five years later. This was one of the largest market shocks in recent history but it perfectly illustrates the dangers of investing, particularly if you’re forced to cash in during such a period.
By contrast, if you’d invested £10,000 five years ago, it would now be worth over £15,622 – and you’d have more than trebled your money to £30,328 if you’d invested twenty years ago.
Investing in shares is a medium to long-term strategy (more than five years) and not for those who need quick access to their savings.
If you do need regular access to your money or need to cash it in within the next couple of years, then safer assets such as cash or deposit accounts may be more suitable. Your savings are less likely to fall in value in absolute terms but returns could be so low that inflation erodes their value in real terms.
As you can see from the chart below, your £10,000 would only be worth £11,011 today if you’d invested in cash (the orange line) over £5,000 less than if you’d invested in shares (the blue line). And given inflation (the grey line) rose by 26% over the period, the money in your pocket is effectively worth less than when you started.
For this reason, cash is perhaps not the best investment if you’re relying on it to provide benefits such as your pension in twenty years’ time.
2) Keep some in cash
Ideally, you should never leave yourself with no choice about when you cash in an investment. If markets take a turn for the worse and you have enough money in your bank or building society to cover your monthly commitments, or until markets recover, then you won’t be forced to sell investments at the wrong time and at a loss.
3) The importance of diversification
Having a mixture of different types of investments in your portfolio is a less risky strategy than investing in just one market or company. It means that, even if one of your investments runs into trouble, you still have the potential to gain from others.
Diversification means spreading your investments across different asset classes (shares, bonds, cash, and property, for example), geographies, and types of business (technology, pharmaceuticals, financial services and so on). Even different sizes of company helps reduce risk, as small companies will perform better in certain markets than big companies and vice versa.
The benefits of diversification can be seen in the chart below, where you can see that the diversified investment has weathered the stock market crash much better than UK shares alone. If you’d been 100% invested in shares during the credit crunch (the blue line), you’d have seen your £10,000 investment fall by almost 40% to £6,194 but it would only have fallen by half that amount if you’d invested in a mix of investments (the orange line).
This may sound complicated but fortunately there are lots of off-the-shelf funds that have diversification built in. They pool investors’ money together to buy a basket of shares or bonds – that way they’re spreading risk across a number of different companies. Of course, if you invest in a UK fund and the UK market falls then your fund is very likely to fall too, so either choose from one of the many multi-asset funds (diversified across asset class and global markets) or if you’re more confident, pick a basket of funds yourself.
Ultimately, you want to avoid being over-reliant on a single source of returns, and that includes all your investments, including your property and bank accounts.
4) Don’t try and time the markets
The temptation to sell when things are going badly and buy only when they pick up again is natural, but history has shown that when markets turn, they can do so quickly and dramatically. There’s a more than even chance you’ll end up actually buying when stocks are most expensive and selling when they’re at their cheapest, the worst of all worlds.
One way to dampen the effect of bad market timing is to invest regularly over a long period. When you pay into an investment or pension plan, you buy units. Each day the price of these units changes, depending on how the fund is performing. By investing regularly, for example every month, you can ‘smooth out’ the highs and lows when stock markets are volatile. This is because when prices are low, your investment buys more units than it would when prices are high. When markets rise, the value of the units will rise too.
5) Attitude to risk isn’t set in stone
Of course, your ability to tolerate loss matters, but don’t place too much emphasis on it. You might have a completely different attitude to investing a small portion in an ISA for a holiday compared to investing your pension pot.
Your attitude to risk more often depends on whether you can afford to lose money. If retirement is looming, your investment strategy should, quite rightly, become more cautious. By then, you’ll have a lot more to lose and less time to recover. If you’re younger and can ride out the peaks and troughs of the stock market, you may feel you can take greater risk. And, you may even feel you have to if you’ve started saving a bit late and won’t have enough in retirement to maintain your standard of living.
6) If in doubt, get advice
It can be helpful to get professional advice, even if you’re a confident investor. An adviser will look at all your sources of income and your financial commitments to assess how much disposable income you have to invest and how you can achieve your objectives in the most tax efficient way.
Nick Dixon is investment director at Aegon