Any investor who is just starting out will likely have a twofold objective: make good profits and keep risks to a minimum. If you’re one of those investors, this article is for you.
The whole point of investing in the financial markets is to enhance your profitability and achieve a better return than you’d get by parking the money in your savings account and earning piddling interest on your capital. There are plenty of financial instruments that offer far more attractive returns than your bank account. However, with greater returns come greater risks. It’s a truism, but truisms are frequently forgotten: when it comes to investing, profitability is commensurate with the risks the investor is willing to take. A smart investor aims to earn a healthy rate of return while managing risks in a way that will prevent the investor from incurring avoidable losses.
How do you become a smart investor? Start by honing your knowledge of financial markets. Without a solid grounding in investing, you will find yourself adrift, which is the fastest route to losses. The most successful investors tend to have studied the financial markets very thoroughly. You need to understand the kinds of financial instruments available to you and the kinds of risks that they present.
Once you have amassed the knowledge necessary to invest in the markets with confidence, you can move on from theory to practice. There are a number of rules that you would do well to follow if you want to avoid making costly mistakes. These rules can be thought of as the five tenets of smart investing.
The first of these five tenets holds that it is necessary to have a safety net before you commit yourself to investing your money. A safety net is simply a certain amount of money set aside to provide for you and your family while you familiarize yourself with the financial markets. These funds will act as a cushion for you and your loved ones if your investing endeavours do not meet with success. To wade into the financial markets without a safety net is foolhardy. How much should you set aside? A good rule of thumb is to earmark the equivalent of six months’ worth of your average monthly expenses as your safety net. In other words, if your household needs $4,000 per month to maintain its lifestyle, you’ll need to set aside at least $24,000 to make sure your household is protected.
Naturally, if you have other investment sources that can provide a cushion for your family, then the above will be either open to adjustments or not applicable at all.
The second tenet is concerned with risk management. Risk management is a cardinal aspect of investing; if you don’t control your risks, you will lose money. The good news is that managing your risks need not be very hard if you exercise self-discipline and avoid getting carried away. Risk management is really all about controlling one’s greed. The desire to make a fortune quickly is natural; to act on this desire is unwise.
When it comes to managing risks, there are a few simple guidelines that should serve you well. You should never commit more funds to any one position than you’re willing to lose. Develop a sense of your risk tolerance, establish clear limits based on that tolerance level, and never exceed these limits. You should also start with only a small deposit – if you make mistakes early on, as is quite likely, it is better to risk a smaller amount than a larger one. Do not fall into the trap of feeling that you need to make a lot of money right away; there will always be opportunities in the future. Your goal should be to acquire the kind of experience that will let you take advantage of these opportunities the way smart investors do. Finally, you should steer clear of leverage; never borrow funds for investing purposes, as doing so will probably turn you into a debtor.
The third tenet revolves around diversification. It’s important to pursue diversification with your investments. Smart investors rarely put all of their eggs in one basket. A diversified portfolio will protect you against poorly made decisions and adverse developments insofar as they concern a specific investment or a certain sector of the economy. It is prudent to diversify across different financial instruments as well as across different sectors of the economy. For example, if you invest in the equity market, you will want to make sure that you have a reasonably balanced portfolio that holds investments in a number of diverse industries (e.g., financials, pharmaceuticals, technology, energy, etc.). If all of your investments are in oil companies, for instance, the market value of your portfolio will take a hit if oil prices fall. Spreading your capital across different industries ensures that the financial damage from any such hit would be limited. You’ll probably encounter different opinions about how much, exactly, you should allot to each sector in percentage terms; whichever opinion you choose to follow, your goal should be to avoid being overexposed to any one sector.
According to the fourth tenet, you should consider collaborating with other investors. Investment pools have become increasingly popular in recent years. Percentage allocation money management (PAMM) accounts, in particular, have gained a following. A PAMM account is an account in which a number of investors pool funds together and give a professional money manager discretionary authority to invest these funds in the forex market. The money manager cannot use the funds in the account for anything other than investing purposes. Typically, in this kind of arrangement, the money manager gets a cut from any profits made on the investments. Profits are distributed and losses are shared among the investors on a pro rata basis. A cap on losses can also be agreed upon: if losses reach a predetermined percentage of the account size, the money manager will cease all trading operations. PAMM accounts offer leverage since larger pools of funds magnify profits. You will not be able to obtain this kind of leverage if you are trading on your own (unless you borrow funds, that is, which you should never do).
The idea behind the pooling of funds is that strength is in numbers. Some investment projects require a considerable investment. You might not have that kind of money available for investing, or perhaps you might not be willing to allot an amount of that size to a single project. Getting other investors involved will make the investment more accessible and reduce your own risk. Such collaboration is smart investing.
The fifth tenet involves passive income. Smart investors understand the importance of looking for sources of passive income, which includes dividends and rental income. The most attractive feature of passive income is its stability. Financial instruments such as equities and currencies can be volatile, which can – and does – lead to variability in returns. Passive income helps the investor mitigate against this variability. Passive income also provides an income stream that can serve as a cushion while you invest in assets that offer less consistent returns. It is therefore important to incorporate passive income into your investment strategy in order to introduce an element of stability into your earnings, make your income more predictable, and provide a safety net as you pursue other investment projects.
While every investor wants to be a smart investor, not every investor actually succeeds in becoming one. Embracing the five tenets of smart investing mentioned above will help you invest profitably, keep risks as low as possible, and get the financial markets to work for you. In short, it will help you become a smart investor.