Tuesday, 21 February 2012

Principles of rational investing


In investments, like in most things in life, it all boils down to using the right methodology. How can we determine what is true? What facts are relevant? Which predictions make sense? Can we figure out the future by applying principles extracted from experience?

"If you intend to climb a high mountain, always choose the smoothest path," wrote Chinese philosopher Lao-Tzu in the year 520 BC. In times of economic adversity, investing becomes the equivalent of climbing the Swiss Alps bare-handed in the middle of the winter.

After suffering the negative results of wrong financial decisions, many individuals are reluctant to place any money in the stock market. Are those fears justified? Making mistakes is inevitable in any human endeavour. A wise man must be willing to accept occasional errors and use them as stepping-stones for building a better future for himself. Why should we not view the stock market in the same way?

The main lesson to be drawn from past financial mistakes is that, when it comes to investing, methodology is everything. More careful research can help us make better decisions in the future. A more disciplined approach can minimize losses. Taking appropriate measures to reduce risk should prevent us from making the same faults twice.

The following principles of risk reduction have endured the best and worst of times. Use them to your advantage to build a prosperous financial future. From time to time, your decisions will not be correct, but if you adopt a prudent strategy, you can keep your losses under control at the same time that you let your profits grow.

[1] Choose shares of solid companies, preferably those that pay regular dividends: Unless you are a professional investor, it is advisable to avoid speculative stocks of small enterprises whose future is dependant on one single product or customer. During periods of economic adversity, well-established companies whose products fulfil fundamental human needs tend to fare better than small undertakings.

[2] Never place more than 5% of your savings on a single investment: Even if you make a correct decision today, circumstances continuously change. The easiest way to minimize risk is to spread your savings into many different assets. The rule of 5% implies that, over time, you should aim at having at least 20 different types of investments.

If you save money every month, it will take you less than two years to achieve this target. Risk reduction is worth the effort of researching 20 different investments. Some of them will turn out to be outstanding places for your money, while others may deliver negative results. Since you cannot know in advance, you will be better off by spreading your money.

[3] Diversify your assets amongst different sectors and countries: You have no control over what problems will affect specific industries or countries in the future. Those negative events are, to a great extent, unpredictable.

Follow the example of professional investors and spread your savings amongst different types of assets. If you diversify internationally by placing a good part of your savings in stable countries around the world, your financial future will be less affected by problems in any particular territory.

[4] Understand that nobody can predict trends with certainty, such as when the markets have hit bottom or are about to crash: You should never act blindly on someone else's advice, no matter how brilliant their track record is. Everybody makes mistakes and, as a general rule, it is better to trust facts than opinions. Listen to wise individuals, but always check things for yourself.

[5] Save regularly, monthly if possible, in order to ensure that you will also invest during periods of pessimism. Psychologically, it is easier to place your money in the stock market when prices are rising than when the world seems to be falling apart. Nevertheless, periods of economic misfortune tend to be the best to purchase assets at a low price.

This last principle is the most difficult to apply, since it requires enormous self-discipline. If we overreact to painful past experiences, we will overlook great investment opportunities. When the stock markets of the world go through a difficult period, the low prices can offer excellent possibilities for the future. If you adopt the habit of investing regularly, you will be able to make profitable decisions when few are willing to take any risk.

The essential principles of risk reduction will not provide you absolute protection, but they can help you keep your losses to a minimum. Whatever your strategy, check the facts for yourself and never trust anybody blindly.

Times of economic adversity are often the best to rebuild an investment portfolio. As Lao-Tzu observed twenty-six centuries ago: "Truth is often paradoxical. Don't make the mistake of believing that you know what you don't know." Making risk reduction a part of your financial plan can help preserve your peace of mind as much as your savings.

[Text: http://johnvespasian.blogspot.com]

[Image by obbino under Creative Commons Attribution License. See the license terms under http://creativecommons.org/licenses/by/3.0/us]