Principles of Successful Investing

Article #5 by Adrian Gafà - Published Monthly

The investment world may confuse many individuals either because they do not understand the mechanics and how to start investing or possibly also due to disappointment with the results achieved. This article attempts to highlight the main principles of successful investing.

Before an investor begins building an investment portfolio, the first thing that needs to be established is the investment objectives. The investor should define the reason behind the investment and the target that is being sought. The objectives vary widely from one person to another given the differing financial situations and unique circumstances of each person. The most common objective is to save money throughout one’s working life to subsequently sustain a certain lifestyle upon retirement. Others may include, investing to acquire a property in the future or investing to generate additional wealth from idle savings over time. The objective set must be realistic and congruent with the other considerations described below.

The investor must also establish the time horizon within which the investment objective must be reached. Ideally, the time horizon is of a long-term nature as a longer timeframe would probably yield the best outcome. In fact, various studies over the years have confirmed that longer-term investment strategies have yielded superior returns that have been partially attributed to the re-investment of income on the portfolio (including dividend, interest, and realized profits) which in turn leads to compounded returns.

When setting one’s objective, an investor needs to also take into consideration the human capital as well as financial capital. Human capital is a measure of the potential earning power of a person’s skill set whilst financial capital is the amount of money a person has managed to save. As such, a university student who has just graduated has a higher level of human capital as he is still starting his career as opposed to another person approaching retirement. On the other hand, it is likely that the person approaching retirement has a higher level of financial capital. Therefore, as human capital decreases, one should be more cautious in his investments as the ability to recoup any losses is limited.

This leads onto another important consideration – risk tolerance. It is important to highlight that investing means taking a risk for a potential return. Given that every person has his/her own set of circumstances, one must assess the willingness as well as the ability to take risk. Willingness to take risk is a personal choice and largely depends on the investor’s character. On the other hand, the ability to take risk depends on the investor’s time horizon, expected income and the level of personal borrowings compared to the level of wealth. The two assessments might be conflicting. For example, an investor might be willing to take on more risk but is unable to do so or vice-versa. In this case, it is always best for an investor to abide by the assessment indicating the lowest risk tolerance.

Once the investment objective and risk tolerance levels have been established, an investor can start building his investment portfolio within these set limits. At this stage, an investor must understand the different asset classes and their respective characteristics. The most popular asset classes are equities (or shares), bonds and cash. Through an investment in equities, an investor acquires a share of the company and therefore participates in the company’s success or otherwise. Meanwhile, when acquiring a bond, an investor would be lending money to a company and in return, receives interest periodically. Therefore, the portfolio must be apportioned accordingly across the different assets classes in line with the investor’s objective. In general, equities are more adequate for higher risk tolerance investors with long-term objectives. Meanwhile, bonds are more suitable for investors with lower risk tolerances and shorter time horizons.

Another important principle for successful investing is diversification. In fact, apart from apportioning your investable sum across different asset classes, an investor must then also diversify across companies, sectors, industries, geographies and possibly also across currencies. Financial theory dictates that 25 to 30 uncorrelated securities should provide the most effective reduction of ‘unsystemic’ or risks specific to each investment in the portfolio. Financial theory also dictates that once a portfolio exceeds thirty securities, the diversification benefits from each additional security is minimal and could also be outweighed by trading costs.

Nowadays, diversification can also be obtained through certain instruments like Exchange-Traded Funds. These are commonly referred to by the acronym ETFs and allow investors to acquire exposure towards multiple companies through one security. There are numerous ETFs nowadays which can assist investor to diversify across sectors, geographies and also asset classes (equities, bonds or commodities). Some ETFs reinvest any dividends immediately (accumulators) while others distribute a dividend periodically (distributors).

Furthermore, it is also important to highlight that no portfolio can ever be risk-free as ‘systemic’ or market risk, including risks related to inflation, political uncertainty and military actions, can never be completely diversified away especially in today’s globalized world.

Investment decisions must not be taken lightly and without due consideration to various factors. Investors should be well informed before making any investment decision. The internet provides various sources of information including financial websites such as Bloomberg, Reuters and CNBC. Moreover, the investor relations webpage of companies usually provides detailed company-specific information which can be of great interest to those who have the time and knowledge to perform research. On the other hand, those investors with limited knowledge and experience in finance, should always seek guidance from a professional.

Ultimately, investors should always base investment decisions on fundamentals and not on market chatter or simply mimic the investment decisions of a relative, friend or colleague. Investors must always be conscious of the fact that different people have different objectives and risk tolerance levels. Therefore, investors should abide by their own investment plan and reach a rational conclusion based on facts.

An investment portfolio needs to be reviewed periodically. Investors must follow developments in the companies in which they have invested and act accordingly. In certain cases, investors must overcome the ‘loss-aversion’ bias and sell an investment at a loss if the investment case is no longer valid. On the other hand, investors must not be too greedy and challenge the ‘status-quo’ bias by selling a profitable investment which is now being considered overvalued. These are just two emotional biases which, through experience, investors must learn to control – a very difficult task indeed. Investment decisions impacted by emotional biases could lead to excessive risk which in turn may lead to undesirable outcomes. In certain circumstances, investors must be patient and not be disheartened by unfavorable short-term market movements as long as the underlying investment case is still valid.

Additionally, investment portfolios must also be rebalanced in line with any changes to the investor’s objectives, time-horizon or risk tolerances as the investor’s circumstances and financial situation may change over time.

Although there is no guarantee of success on each and every investment undertaken, a well-diversified portfolio should generate adequate returns for investors over the long-term. As such, investors should be diligent in their approach to investments and abide by the principles highlighted above whilst seeking professional assistance when necessary.

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