There are fundamental principles of investing that apply to each of us whether we are seasoned portfolio managers or a novice investor. It never hurts to take time to periodically review these important concepts and improve our foundations upon which we make investment decisions.
Here are 6 fundamental principles of investing I use to make myself the best portfolio manager I can be. Notice many of these principles are inter-linked.
Fundamental Principles of Investing
1. Asset Allocation is # 1
Studies show that how you divide your assets among asset categories will be the most important determinant of your portfolio returns. This means you should put a maximum effort into asset allocation.
2. Proper Diversification
Asset allocation is the most important form of diversification. But risk can be reduced further by properly diversifying each asset category. Risk that is specific to owning a particular company or industry can be diversified away by owning a variety of non-correlated assets.
3. Control Your Own Destiny
Whether you manage your portfolio completely on your own, or obtain outside help (from a company such as the Arbor Investment Planner ), make sure you are in charge of your money. Too many people lose everything by trusting someone else with their money. It makes sense to stay in control of your accounts.
4. Understand the Power of Compounding and Reverse Compounding
Exponential or compound growth is the most powerful principle of investing. The years of compound growth is one of the most important factors in the value of your portfolio. Starting at age 25, a $300 monthly investment earning 8% will build a portfolio of 1 million dollars at age 65. Starting at age 45 will require a $1700 monthly investing for the same outcome.
Reverse compounding can totally devastate a portfolio for many years.
If you lose 10% of your portfolio it takes an 11% gain to get back to breakeven.
If you lose 50% of your portfolio it takes a 100% gain to get back to breakeven.
If you lose 70% of your portfolio it takes a 233% gain to get back to breakeven.
5. Emphasize Risk Management
The laws of compounding make risk management a crucial part of investing. If you preserve your capital in a bear market, not only have you not suffered large losses, but you have capital available to invest at much lower prices!
Risk management means purchasing investments with a “margin of safety”. Think about what can go wrong with that investment and how badly it would affect the value of that investment. A company with little debt and lots of cash can better withstand a setback than a company without these advantages.
6. Make Volatility Your Friend
Most investors buy high and sell low because they let their emotions control their actions. Market volatility is a fact of investing in the stock market. Always have cash available to buy investments when they are “on sale”. It’s also a good idea to lighten up investments after a good run higher. No one ever goes broke taking large profits.
Avoid portfolio volatility because it destroys your long term returns. I use a tactical asset allocation strategy which gives me the flexibility to raise allocations to categories that offer good value. At the same time, I can lower or avoid categories that are expensive.
If you can embrace these fundamental principles of investing you will be miles ahead of the majority of investors. These timeless investment principles can make a gigantic difference in helping you meet your goals and providing the kind of retirement you desire.
Related Reading: Investment Basics