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Five investment rules to always remember

By Zoran Temelkov

The difference between successful and unsuccessful investors is in the discipline they have and the rules of investing they follow.

Five investment rules to always remember

Being a successful investor means that you need to get familiar with specific rules and investment tips. There are numerous rules of investing, so it is easy to understand and remember them if we group the rules into five categories. They are money management rules, portfolio management rules, diversification and allocation rules, the money increase rules and the greediness rule.

Money management rules

Define your financial objectives – before you start investing, you need to define the purpose of starting the investment adventure. Some of the reasons as to why people invest are the desire to reach financial freedom, the desire to retire early, to supplement their income during retirement years, to purchase a capital item, etc. Your objective will have an impact on your money management strategy as well as an investment strategy and accordingly, on your portfolio. For example, investors planning to supplement their retirement income may develop a long-term strategy and consider investing a portion of their money in 30-year bonds or stocks. On the other hand, if you invest with the purpose to have enough money to purchase a property after 10 years, investing in a 30-year bond can be somewhat an inadequate investment.

Make a financial plan for your investments – you should define how much money you will put toward your investment and whether you will make a regular investment or one-time investment. If you decide to make a regular investment, you should specify the amount you will invest each month, quarter or year. When creating your investment plan, you can use the 50/30/20 rule under which you should save or invest at least 20 per cent of your income.

Define how much money you can afford to lose before you make your first investment. Accordingly, you should never invest more money than what you can lose without any negative effect on your lifestyle. Hence, investors should be careful when defining the amount, they can invest, which in case of losing it will not have any impact on their future investment plans. Also, the money management strategy should be defined in a manner in which you will have enough money to continue your investing activities.

Pay attention to the costs associated with your investment – you do not want to end up as an investor who makes enough to cover the transaction costs and other relevant costs. Remember to look for brokers with low fees and commissions.

Portfolio management rules

Portfolio management is another important aspect which should be considered when investing. This category of investment rules considers the way in which you will manage your portfolio, which will serve as a base to define your portfolio management strategy. In essence, investors can go with active or passive portfolio management.

With active portfolio management, you will constantly buy and sell assets in an attempt to make higher profits and beat the market. Therefore, you will need to perform analysis and monitor the market movements in order to find profitable opportunities. Of course, as you will be executing transactions more often along with the constant analysis, you will also have a higher level of costs as well as commissions and fees.

If you decide to go with the passive portfolio management, you will make a well-diversified portfolio and try to make the same or similar return as a specific index. When you chose to conduct a passive portfolio management strategy, it would mean that you will not be executing regular transactions. Thus, there is no need to perform an analysis of new opportunities regularly.

Diversification and allocation rules

Diversification is one of the most important aspects that should be remembered by investors. It is the process through which you are limiting the exposure to one asset by holding multiple different assets in your portfolio. There are different rules which can provide guidelines to create a diversified portfolio through proper allocation of your funds. Some of the commonly quoted rules of investing are the 100 less age rule and the 5 per cent rule.

The "100 less age" rule of thumb which may be used by investors is to subtract your age from 100 and the resulting number will show you what percentage of your portfolio should be composed of stocks; the remaining percentage can go towards bonds or other instruments. Hence, if you are 35 years old then 65 per cent (100 – 35) of your portfolio should consist of equities. In accordance with the rule, the older investors will hold a more conservative portfolio while the younger investors will invest a bigger portion of their money in stocks. There is also a modified version of the "100 minus age" rule and the new rule is "120 less age" which should give you the percentage that should be invested in stocks. The updated rule is considered to be used by investors with a high-risk tolerance.

Another rule regarding the investment's dals with the decision about how much of single security to hold in your portfolio and a well-known quotation to remember here would be "Do not put all your eggs in one basket." There is the 5 per cent rule which states that you should not invest more than 5 per cent of your money in one (same) security.

Keep in mind that when deciding how to allocate your funds and maintaining a diversified portfolio, you need to choose to invest in asset classes with different levels of risk. So, you may buy shares from different companies, but none of the individual stocks will be more than 5 per cent of your portfolio.

The investor should also know what percentage of the portfolio will be at low risk, medium risk and high-risk assets. The rule here would be that younger investors with adequate income can have a bigger percentage invested in riskier assets, whereas the elderly investors should allocate a more significant percentage of their portfolio in the less risky asset. The allocation of your money and the composition of your portfolio largely depends on what you want to achieve with your investment in terms of your financial objectives.

Knowing the double, triple and quadruple periods

It would be practical if you know how to calculate the time period needed to double, triple or quadruple your money in the future using certain rules. Knowing the rules can be beneficial if you plan to purchase your home sometime in the future. Hence, good rules every investor should know are the rule of 72, rule of 114 and the rule of 144.

The investment rule of 72 shows you how long it will take you to double your money at a fixed annual rate and the calculation based on the rule is rather simple. Assuming you may invest your money in an instrument with an annual rate of return of 7 per cent. To find how many years it will take for you to double your money, you simply divide the annual rate by 72. It turns that at 7 per cent return you will double your money after 10.2 years (72/7).

The investment rule of 114 gives you an opportunity to calculate the time needed for your investment to triple for a specific interest rate. Considering the example of with the 7 per cent annual rate of return, it will take 16.28 years (114/7) for your investment to grow three times.

The investment rule of 144 follows the same logic as the other two rules with the difference being that this rule shows you in how much time your investment will quadruple. At a 7 per cent annual rate of return, your investment will grow for times in 20.5 years (144/7).

It should be noted that these rules do not provide the most accurate number of years, but they do come close and are rather practical in the investment decision because of their simplicity. Of course, there are also some variations to these rules and also you may find some other similar number rules.

The Greediness rules

Greediness is one of the biggest enemies of the investors because it can be the reason for many wrong decisions. Some investors fail because they think that investing is a get-rich-quick scheme, which is far from being true. Keep in mind that when you invest your money, it means that you will build wealth in the long run for and that reason, you should remember that you need to be patient.

Make sure that you have defined your exit points and stick to them. For instance, when you invest money, you can specify an exit point in terms of time such that you will sell off your portfolio after 20 years. If you apply active management strategies, then you need to set a take profit and stop-loss points. As soon as the price hits your desired price level, you should sell the security, do not become greedy and wait for the price to go up a bit more. Many investors share a variety of investment tips from their personal experience and it would be beneficial for every investor, especially a new one, to go through them. The investment tips can provide you with an insight into the way you can prepare themselves from the psychological, financial and analytical aspects of investing. Finally, do not forget that you should have an investment plan which can help you to avoid the greediness trap when setting up your strategies.

FURTHER READING: How to control emotions while trading

FURTHER READING: Is your trading suffering from the disposition effect?

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