As a financial writer living in a university town in southern England, young people often ask me about the core principles of investing. I happily provide them with free advice, as well as recommending good books on the subject. Here are five principles that I aim to get across to newbie investors.
1. Investing isn’t gambling
Many adults (of all ages) genuinely believe that investing in shares is no different to gambling. But gambling (playing games of chance) always comes with a ‘negative expectation’. For example, UK National Lottery games return only half of ticket sales in prizes. Thus, these have a negative expectation of 50%, which is truly terrible. I usually quote US fund manager Peter Lynch, who wisely said, “Although it’s easy to forget sometimes, a share is not a lottery ticket…it’s part-ownership of a business”.
2. Spread your risk
One of the most important rules of investing is to diversify your wealth. This involves spreading money across equities (stocks and shares), property, bonds, cash, and other assets. By distributing our precious nest eggs across many baskets, we avoid being overly exposed to one particular asset, market sector, or company. Diversification also reduces concentration risk, which involves having too much riding on one specific asset. Failing to diversify produces portfolios that suffer from excessive volatility and risk.
3. Don’t forget dividends
The returns from investing in shares are twofold. First, capital gains: selling shares for a profit. Second, dividends: a regular cash income paid to shareholders. Many listed companies return cash to shareholders as quarterly or half-yearly dividends. Not all companies pay dividends, but most members of the FTSE 100 index do. The average forecast dividend yield for the FTSE 100 is currently around 3.8% a year. Failing to invest in dividend-paying companies means losing this passive income. Some research suggests that reinvesting cash dividends into yet more shares can account for up to half (50%) of the long-term returns from shares.
4. Beware of leverage
In investing, leverage involves using borrowed money or financial derivatives to magnify the gains (and losses) from financial assets. The problem with leverage is that is it indiscriminate. Like a double-edged sword, it can harm as much as help. For example, let’s say I borrow £100 and invest it alongside £100 of my own money into a particular stock. If that stock halves in value, then my entire £200 will be wiped out. Excessive leverage wiped out the $20bn fortune of this US billionaire in mere days. Always remember: leverage is your best friend, until it’s your worst enemy.
5. Trading isn’t investing
It’s vital to understand that trading isn’t investing. Trading involves taking short-term positions in, say, shares, currencies, commodities, and so on. If I buy an asset and immediately start thinking about when to sell it, then I’m short-term trading and not long-term investing. Traders usually aim to make quick money from small market movements over short timescales. Investors buy assets, particularly shares in good companies, with the aim of making superior long-term returns (sometimes over many decades). Almost anyone can be a successful investor, but rich traders are rare as hen’s teeth. Finally, if you get a buzz of dopamine (the feel-good neurotransmitter in your brain) when you’re dealing, then you’re probably trading and not investing. While investing can be boring, it really, truly works!