9 Fundamental Principles that one must follow while Investing
Almost everybody knows that wealth creation is a marathon race, but still many practice sprints. While a marathon focuses on the long run, a sprint focuses on the short run. Financial magnets like Warren Buffet and Carlos Slim have reaped the benefits from long term investment planning & value investing, not sprinting.
Discipline and long-term planning are key ingredients of investment. Whether you’re a seasoned portfolio manager or a novice investor, some fundamental investment principles apply to everyone.
In this article, we will decode the important investment principles you can apply in your investment strategy.
1. Establish a realistic financial plan based on your goals
Before investing, define your life goals. Are you planning for early retirement or considering buying a second home?
While setting your goals, set a time frame for each one of them. Once these goals are set, it will become easy for you to pick types of investments that will give you those returns.
Everyone wants the highest return on their investments without much risk. Unfortunately, there is no such investment. Low-risk investments will often yield lower returns and vice versa.
Depending on your plan & risk appetite, you can invest in stocks or equities, bonds, forex, cryptos, ETFs etc.
So, it’s important to set realistic goals and be ready for some bumpy roads ahead. Have patience, Rome was not built in one day.
2. Start Saving and Investing early
Develop a habit of saving at an early age. Don’t wait for the right time, there is never going to be a better time than now.
For instance, if someone had invested just $1000 in Apple stock in 1981, his investment in 2021 will now worth more than 1 million dollars.
It doesn’t matter how much you earn right now, park some percentage of it for investments. Plant your seeds today to enjoy the fruits of tomorrow.
3. Embrace/Follow an Investing Strategy
Do you know what kind of investor you are?
As you know Messi and Ronaldo both are world-class footballers but they differ in their playing style, similarly, every investor has their investment style.
Some are value investors, while some like to play on the edge. Generally, there are five kinds of investors:
- Value Investing: They look for highly discounted stocks (those who are trading at less than their perceived true intrinsic value). Benjamin Graham and the likes of Warren Buffet are best-known value investors. If you’re a value investor, you are more likely to choose assets that may be currently trading at lower prices but has the potential to gain in the future.
- Contrarian Investing: Those who like to play against the prevailing market sentiments & trend. They sell when everyone is buying, and vice versa. They pay lip service to market noise. If you like the investment philosophy of Carl Icahn, your investment strategy can be buying something “when no one wants to it”. This strategy is more suitable for those having a higher risk appetite & you must do your due diligence to find undervalued assets.
- Growth Investing: Investment in young companies and startups that have although lower valuation at present but are expected to rise in the future. It’s suitable for both short term & long-term investments, an example of that are stocks like Tesla, Nio, First Solar etc. that related to green energy sector.
- Growth at a Reasonable Price: The term was coined by Wall Street giant, Peter Lynch. This investment strategy combines both value and growth investing. They invest in stocks that are not overly valued but show consistent growth.
- Momentum Investing: It’s a kind of market-beating strategy, which consists of buying stocks that had high returns in the past weeks or few months, and selling those that had poor returns in the same period. It requires complete attention and knowledge of technical indicators and high capital at disposal, also the risks associated are much higher.
4. Diversification and Asset Allocation is Vital
Generally, small investments in several assets are considered a good investment strategy.
Everybody thinks that they can beat the market, but unfortunately, that’s nearly impossible to be correct all the time. If your portfolio consists of five or ten assets diversified across different sectors, you are more likely to survive even when the market is bearish.
As an example, some sectors did bad during Covid-19 pandemic, while stocks of companies related to tech were booming. If an investor had a diversified portfolio, the risk would be lower & spread across multiple sectors.
However, avoid over-diversification or under-diversification. Over-diversification can make you less likely to gain significantly from your investments. The latter may result in substantial losses in unfavourable market conditions.
5. Minimize fees and taxes
Nigerian stockbrokers charge max 1.85% of investment size when you buy a stock, while max 2.4% every time you sell. Although, these fees can be much lower depending on the broker.
Brokers’ commission vary, so choose a broker that has a transparent policy and there are no hidden charges. Plus, you must ensure the broker is regulated and licensed by NSE.
Similarly, if you are trading in the forex market, different brokers charge different fees and spread. There are no regulated forex brokers currently in Nigeria, so you must compare all the best forex brokers that are regulated with regulators like FSCA in South Africa & FCA in UK, check their reviews, and then choose a broker that has lowest spread and lowest commission per trade. The exact fees will depend on the instrument that you are trading & your market position size.
Some forex brokers also charge fees of 2-3% during funding & withdrawals. These expenses might look small but over time it can reduce your actual returns or even cause loss to you if the broker charges too much.
Similarly, tax on capital gains can further reduce your actual ROI (return on investment). You should probably invest some amount in tax-saving schemes and assets like mutual funds, Nigerian government securities, saving bonds, etc.
6. Invest for the Long Term
Patience is key.
It’s unlikely that you have heard about Prince Alwaleed Bin Talal if you are starting fresh in the investment world. But he is a well-known name on Wall Street. When everybody was selling Citicorp in the 1990s, he holds his investments and became one of the largest shareholders in Citigroup.
Do your research and have faith in yourself (not in the market), the best moves are made when the market is volatile.
7. Hedge against significant losses
Any kind of investment is not immune to risk. Nobody knows when the next market crash coming or the next pandemic which will cause panic in the market. That’s why it’s important to hedge against possible risks.
Minor losses (average up and down) are fine, but significant losses can take years to recover.
There are several investment tools and hedging strategies that you can use to minimize risks. Tools such as ‘long put position’, ‘fence’, ‘stop-loss’ and ‘covered call’ can be effective hedging options.
Diversification is perhaps the best long-term strategy to hedge against the portfolio risk. Having some investment in liquid forms (cash and national saving deposits) can also be helpful.
8. Employ Risk Management Strategies
Every investor has one simple goal – get the highest ROI. But the financial market doesn’t cater to the wishes of investors.
There are two simple rules of being a successful investor – first, never lose; second, never forget the first. That’s rhetoric, not feasible.
However, certain risk management strategies will help you to reduce some of the potential risks:
- Think long term
Long-term investments simply mean holding a variety of assets (stocks, mutual funds, securities, commodities, etc.) for at least a year or more. Short term fluctuations can intimate you to sell off those assets. Think over. Just compare the NSE index price of today with the last five years, you will see there was never a bearish trend on yearly basis.
- Research before investing
Do your research. If you are investing in a stock, first look at the company’s past years’ performance, then at the price. The normally used metric is P/E ratio. Make investments in companies that you understand. It means you should be able to read their financial statements, their current assets, and future business expansion, listen to their conference calls. As Warren Buffet once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
- Know your financial limitations/risk appetite
It can be tempting to invest all the money in the capital market, but not a wise choice. A downturn in the market can destroy your portfolio that will take years to replenish. That’s why it’s important to know your risk appetite. Conservative strategy will help you invest in only those stocks that worth the risk.
- Diversify your portfolio
Don’t end up investing in one stock or limit your investments in one sector. Choose a variety of sectors to avoid the risks. Because in volatile market conditions, sectors go up and down in packs. Diversification will help you to average out losses from one sector with other profit-making sectors. For instance, you can divide your investment portfolio into many sectors: tech, energy, real estate, petroleum, etc.
9. Ignore the noise and stick to plan
The likes of Warren Buffet and Carlos Slim all share one common thing – don’t make decisions based on market noise. They don’t focus on what is happening in present. They analyze the entire economy from an eagle-eye view and see how the present momentum will unfold in the future.
In simple words, their thinking is always future-oriented.
Focus on the bigger picture. Be open-minded. Look for undervalued stocks at discounted prices, they can become hot assets if they continue growing. Early investments in promising new stocks can yield good results. Also, avoid financial market instruments that you don’t know about.