What is the Number 1 Rule of Investing?
The number one rule of investing is to diversify. Diversification is the key to achieving long-term success in investing. Diversification means having different types of investments in your portfolio so that when a kind of investment does poorly, another class will still do well and cushion any losses.
Diversification reduces the overall risk of investing. Investing in just one type of asset or industry limits your risk exposure, as all of your investments are subject to the same market fluctuations. Different investments increase your chances of having one or more of them perform well, even if the overall market is down.
Diversification can take many forms. Investments can be broadly classified into four main categories:
Knowledge (knowledge is power): Stocks, Bonds, Mutual funds, and other equity instruments of the company or corporation offering it.
If the company has good revenue, cash position, and brand name in the market, you should have a minimum percentage of your portfolio invested.
Real Estate: Real estate refers to properties like lands, buildings, condos, and some commercial properties. It is recommended to have a maximum of 5% of your total portfolio in real estate.
Collectibles: Collectible refers to investments like stamps, coins, wine, silver, etc. The market value and popular demand by people define it. A small percentage (in total) of this investment can give you a good return.
Hedge Funds: This investment takes a lot of time and skill to understand and have confidence in them since if it goes wrong, you lose everything. It is recommended to invest at least 5% of your investment portfolio.
U.S. Government Securities: When the U.S. government bonds have a good credit rating and quality, it is also recommended to invest in them as they have a minimum return and a stable interest rate which gives you an additional income over time.
The best places to invest are those subjected to minimal risk and consistently provide a fair return on your capital while limiting the amount of risk you take on overall by having a diversified portfolio. In choosing your investment vehicles, you must consider three fundamental factors:
- The overall financial health of the company;
- The individual company’s financial health; and,
- The overall economy or market climate.
First, look at the market as a whole. It would help if you considered the individual company’s financial well-being too. Investing in some financially troubled companies is a good idea if you have the stomach for the possibility of losing money.
Make sure that you understand the investment you are putting your money in. If you don’t, but the company does well in spite of it, then you will have a positive return on your investment. If you understand the investment and the economy has a downturn, you will likely see a negative return on your investment.
As an investor, there are three basic types of risk: Market Risk, Credit Risk, and Liquidity Risk. Market risk includes short-term risks that affect the market as a whole and long-term risks that can significantly alter a call. A significant factor in determining your market risk is the overall economy, Standard & Poor’s 500 indexes, and the price of oil.
The Standard & Poor’s 500 is a barometer of what’s happening in the overall market. The cost of oil is essential because it affects many different industries, from energy to transportation to chemicals to agriculture. Credit risk refers to the possibility of default. If a company or government goes bankrupt, then you might lose all your money invested in it. Liquidity risk means that you may not be able to sell your investment when you need to.
Second, examine the individual company’s financial health. There are services that can help you evaluate a company’s financial health. Before investing in it, you should understand how a company makes its money and what its short-term and long-term goals are. Is it an efficient, safe, and profitable investment?
The third consideration is the overall economy or market climate. Is the economy growing or declining? What is the unemployment rate? What are interest rates? Are inflation and deflation factors a concern? These are all questions you need to ask before committing your money.
Finally, decide how much risk you’re willing to take on and when you want to make your investments. If you are saving for college, then time is of the essence. If you plan on retiring in the next few years, you can afford to wait to make your investments and enjoy the dividends later. If you have a long time horizon and don’t mind a negligible risk, then investing in some stocks is a good move. If you want to avoid any risks, spread your investments over time.
A good rule of thumb for calculating a percentage allocation to equities is based on the current proportion of your portfolio invested in each of three classes: bonds, cash, and stock funds.