Investing can be a powerful way to build wealth, yet it often seems complex and fraught with risk. Fortunately, there are guiding principles to follow that can increase your chances of success. This blog post dives into the core tenets of investing, backed by statistics and credible sources.
Rule 1: Start Early and Be Consistent
Source: JP Morgan’s ‘Guide to Retirement’ Report
Compound interest has often been hailed as the eighth wonder of the world. The principle here is simple: the earlier you start investing, the more time your money has to grow. The power of compound interest becomes clearer when we look at JP Morgan’s ‘Guide to Retirement’ report, which demonstrates that someone who starts saving at 25 will have significantly more at retirement than someone who starts at 35, even if the latter saves more per year 1.
Rule 2: Diversify Your Portfolio
Source: Modern Portfolio Theory (Harry Markowitz)
Diversification helps manage risk by spreading investments across various financial instruments, industries, and other categories. By doing so, you can mitigate the impact of any one investment going sour. This principle is the cornerstone of Modern Portfolio Theory, for which Harry Markowitz was awarded a Nobel prize in 1990. He showed statistically that a diversified portfolio can maximize returns for a given level of risk 2.
Rule 3: Invest for the Long Term
Source: A Random Walk Down Wall Street (Burton Malkiel)
Historically, stock markets have experienced downturns, yet over the long term, they’ve consistently provided positive returns. Burton Malkiel, in his book ‘A Random Walk Down Wall Street,’ highlights that from 1926 to 2012, a portfolio composed of 50% bonds and 50% stocks never posted a negative return over any 20-year period, reinforcing the concept of long-term investment 3.
Rule 4: Understand Your Risk Tolerance
Source: ‘Determinants of Risk Tolerance’ (Grable and Lytton)
Everyone has a different risk tolerance based on factors such as age, income, financial goals, etc. Grable and Lytton’s study on ‘Determinants of Risk Tolerance’ found that overconfidence often leads to riskier investment behaviors. Understanding your own risk tolerance can prevent you from making investment decisions that you may regret 4.
Rule 5: Regularly Rebalance Your Portfolio
Source: Vanguard’s ‘Best practices for portfolio rebalancing’
Rebalancing is the process of realigning the weights of a portfolio of assets to maintain the desired risk level. According to Vanguard’s research, a portfolio that’s regularly rebalanced has a better risk/return ratio, reducing the chance of portfolio drift – where your investments can end up more risky or conservative than you intended 5.
Rule 6: Invest in What You Understand
Source: ‘The Essays of Warren Buffett’
As Warren Buffett advises, never invest in a business you cannot understand. This rule highlights the importance of research and due diligence before investing. Buffett’s successful track record as an investor reinforces this principle 6.
Investing, when done wisely, can be a catalyst to financial freedom. These six rules serve as a foundation for any investment strategy. While there are no guaranteed outcomes in investing, following these guidelines can increase your probability of success and possibly lead to significant wealth creation over time.
Sources:
Footnotes
- JP Morgan Asset Management. (2020). Guide to Retirement ↩
- Markowitz, H. (1952). Portfolio Selection ↩
- Malkiel, B. (2015). A Random Walk Down Wall Street ↩
- Grable, J., & Lytton, R. (1999). Financial Risk Tolerance Revisited: The Development of a Risk Assessment Instrument ↩
- Vanguard. (2015). Best practices for portfolio rebalancing ↩
- Buffett, W., & Cunningham, L. A. (2013). The Essays of Warren Buffett: Lessons for Corporate America ↩
