Updated: November 21, 2022
Investing takes time and effort. And while many can boast of making an overnight fortune, investment gurus like Warren Buffett will emphasize the importance of understanding and following three golden rules for investing.
Whether you want to make a living from your investment or create a reserve for your retirement, the rules are the same: understand the power of compounding, diversify your investments, and stay calm.
1. Golden rules of investing: harness the power of compounding
Compounding is an incredibly powerful investment force.
Simply put, it is the process by which the returns on an investment continue to generate returns themselves. The most common example is with a simple savings account that earns interest.
If you invest $100 at 3%, at the end of the first year, you will earn $3. However, going into the second year, you are now making that 3% on $103. Hence, at the end of the second year, you will get $3.09 more.
This may not sound so exciting. 9¢ is not going to buy you anything. Even $3.09 won’t get you very far.
However, there are two other factors to consider: scale and time.
The first is obvious, the more you have, the higher the return, 3% of $100,000 is more than 3% of $100. Time, however, is where people often do not appreciate the power of compounding. If you put $100 in a savings account at 35 and forgot until you retired at 65, it would be $242.
So, better returns will result in a more powerful effect.
Using a practical example, the average 35-year-old will have $38,500 in their 401K, and according to Goldman Sachs, the average stock market return over the past 140 years is 9.2%.
So in the first year, the now 36-year-old will have made $3,542. And the amounts increased rapidly. By year ten, the return will have more than doubled to $7,821.
In year twenty, your investment will earn more than $18,857. By the time you retire thirty years later at 65, your 401k will be worth fourteen times your initial investment, $539,684, and you will earn $45,468 a year.
Perhaps the best story on the power of compounding is from Benjamin Franklin. Leaving £2,000 (about $4,000) in his will for Boston and Philadelphia, he stipulated that they will be invested for 200 years after his death.
Both cities adopted different investment strategies, but when the funds became available, the total had risen to $6.5 million.
2. Investment golden rules: diversify your portfolio
It is tempting, when looking for profitability, to focus on investments that appear more profitable.
However, in that case, it also means that one needs to consolidate risk in those investments. And, as everyone knows, the stock market can go up and down and sometimes crash.
An undiversified fund is at risk. A fall could push the value of an investment back for years as it slowly recovers. In extreme cases, the drop can be so great that recovery is impossible and can even wipe out the value entirely.
An example is General Motors. It went, in just a few years, from being a reliable stock, paying a healthy dividend, to being useless when the company went bankrupt. Although these situations are relatively rare, they are not unheard of. An investor who had not diversified his investment would have seen its value disappear.
Diversification isn’t just about individual stocks, either. It’s worth making sure to diversify in multiple ways. Just as individual companies can collapse, so can industrial sectors. And even then, entire markets occasionally crash.
The financial crisis of 2008 and the Covid-19 pandemic caused markets to lose significant value. While that value returned, it took time. Having a diverse portfolio will help mitigate the losses in bad times no matter it includes luxury commodities, property, or even your savings account.
3. Investment golden rules: keep calm
‘Keep Calm and Carry On’ has become a cliche, but the advice is still good. The market, and with it the value of your investment, is in constant motion. And most of the time it’s best not to look at it!
The daily movements of your actions can be interesting to observe, but the responses it generates in most people are not that helpful.
The fight or flight response may be good when in danger, but not when a stock moves a few pennies. Instead, you need to focus on the trend and avoid panic decisions like ditching a downside stock or jumping on a high.
One of the problems with reacting like this is that you are almost always going to be late. The move will have already occurred, so you end up buying high or selling low, the opposite of what you want. And, in general, playing a longer game has benefits; most of the people who saw money lost in their wallets in the 2020 pandemic will have already more than recovered those losses.
A good piece of advice for most investors is to refrain from checking the value of their investment constantly.
If you are thinking of investing in property, then you should check your property’s future value with a house price calculator. This will help them avoid the temptation to act on short-term changes.
If you want to play the markets, then having a small fund to play with that you can afford to lose and can resist the urge to reload is a good technique and could lead to a good profit.
Uniting the golden rules of investing
Patience is, perhaps, the basis of the three golden rules.
Compounding is powerful, but it takes time to develop that power. Staying calm often means that you should wait for market movements and instead rely on longer-term trends.
And even diversification is based on this patience. When you review your portfolio, some parts will perform better than others, but while in hindsight you may have been able to make more money, more quickly, you have effectively exercised patience in exchange for greater financial security.
The golden rules work, which is why investor after investor will repeat them. Because they know investing takes time, but when you put in that time, you reap the rewards.
About the author:
Jonathan is Founder of SPV Mortgages. He can help you find and secure the best limited company mortgage options to push your property investment dreams forward. As a specialist mortgage broker with over 10 years of industry knowledge, he has helped experienced landlords and first-time investors across the country; saving you time and money in tracking down the best rates.