What are the four golden rules of investing?

Starting as early as possible is essential to take advantage of the power of compound interest

A diversified portfolio can help retail investors to manage risk. AP

Investing is a fundamental aspect of personal finance that holds immense importance in building wealth, achieving financial goals and securing a prosperous future.

By allocating funds to various investment vehicles, people have the potential to grow their wealth, beat inflation and generate passive income.

Investing also plays a critical role in retirement planning, allowing one to accumulate a substantial nest egg over time.

Although investments can be a powerful tool for wealth creation and financial security, it requires knowledge and a strategic approach.

The golden rules of investing provide valuable principles to guide people in making informed decisions and increasing their chances of success in the investment world.

These rules are time-tested and proven strategies that have been embraced by seasoned investors.

By understanding and applying these rules, people can set clear investment goals, diversify their portfolios, adopt a long-term perspective and maintain discipline.

Whether you are a novice investor or have some experience in the market, these golden rules will serve as a foundation for making wise investment decisions and maximising your financial potential.

1. Start today

If there was an eighth wonder in the world, it would be compound interest. Let’s understand the power of compounding with an example:

Let’s suppose two friends, Riya and Shreya, start investing $5,000 a year until they are 65 years old.

Assuming an average annual return of 10 per cent, Riya starts investing at the age of 25 while Shreya begins at the age of 35.

While the difference between the amount invested by Riya and Shreya would be only $50,000, the difference in the funds accumulated by the time they turn 65 years would differ by about $950,000.

Riya would have $1.49 million, while Shreya would have only $545,000. That is the benefit of starting early, as compound interest grows your money significantly.

2. Stick to a systematic investment plan

Investors need to keep their emotions in control while investing in markets.

As American investor and author Peter Lynch once said: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

This is because selling out of fear keeps investors out of the market for far too long, causing them to lose a lot of ground in the early days of a rebound.

Data suggest the 10 best days over the past 20 years occurred during the financial crisis of 2008-2009 and during the very first days of the Covid-19 pandemic in 2020.

The value of the S&P 500 has risen by 284 per cent in the past 20 years (excluding dividends), but without those best 10 days, it is only 76 per cent.

While it is not possible to only avoid the best days in the markets, what it implies is that by trying to predict the best time to buy and sell, one may miss the market’s most significant gains.

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Instead of lump-sum financing, investors would be wise to invest in increments, also known as dollar-cost averaging.

Dollar-cost averaging can be an excellent strategy when it is difficult to call out a bottom in such markets.

It is an excellent strategy for investors who want to take advantage of the dip but fear a further sell-off. Whether it is once a week or once a month, investors can put in a little at a time to ensure they are still investing in a structured way, but taking the emotion out of it.

3. Diversification

It is essential not to look for a needle in a haystack but, instead, just buy the haystack.

For example, someone who invested their funds in Tesla would have lost 68 per cent last year, while if you invested in the Nasdaq 100 index, the loss would have been only 34 per cent.

Those losses would have dropped to 20 per cent if you bought into the S&P 500 index and even further to 14 per cent if you had a 60/40 equity-bond portfolio.

Therefore, it is advisable to maintain a broad diversification among asset classes and even sectors to mitigate the volatility.

Investors should diversify in a mix of cash and income-producing securities rather than solely in equities. The goal should be to achieve reasonable returns that outperform inflation while keeping volatility under control.

4. How to start

Decide on your goal – what do you need the funds for and when are they required?

This step is essential as it will help you to decide on the appropriate risk-return strategy.

However, before investing, you should reduce your debt and set aside an emergency fund so you are not forced to sell your fund when markets are down because you need cash.

And remember – start now and invest regularly.

However, it is important to note that investing involves risks and there is no guarantee of positive returns.

It requires careful consideration, an understanding of the investment vehicles and a long-term perspective.

Vijay Valecha is the chief investment officer at Century Financial