The Golden Rules of Investment

Investment takes time and effort. And while there are plenty who might boast about making an overnight fortune, investment gurus like Warren Buffett will stress the importance of understanding, and following, three golden rules for investment. Whether you are hoping to make a living from your investment, or creating a nest-egg for your retirement, the rules are the same: understand the power of compounding, diversify your investments, and keep calm.

1.Golden Rules of Investment : Harness the power of compounding

Compounding is an incredibly powerful force in investment. Put simply, it is the process by which the returns from an investment go on to generate returns themselves. The most common example is with a simple savings account that generates interest.

If you invest $100 at 3% you will, at the end of the first year, earn $3. However, going into the second year, you are now earning that 3% on $103. So, at the end of year two, you get slightly more: $3.09. This might not seem that exciting. 9¢ is not going to buy you anything. Even $3.09 won’t get you far.

However, there are two other factors to consider: scale and time. The first is obvious, the more you have, the bigger the return, 3% of $100,000 is more than 3% of $100. Time, however, is where people often fail to appreciate the power of compounding. If you’d put $100 in a savings account at 35 and forgot about until you retired at 65 it would be with $242.

And the better the returns the more powerful the 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 earned $3,542. And the amounts increased rapidly. By year ten the return will have more than doubled to $7,821. In year twenty, their investment will earn over $18,857. By the time they retire thirty years later at 65, their 401k will be worth fourteen times their initial investment, $539,684, and earn $45,468 a year.

Perhaps the best story about the power of compounding is from Benjamin Franklin. Leaving £2,000 (around $4,000) in his will to Boston and Philadelphia he stipulated it be invested for 200 years after his death. Both cities adopted different investment strategies, but when the funds became available the total had grown to $6.5 million.

2.Golden Rules of Investment : Diversify your portfolio

It is tempting, when looking for returns, to concentrate on investments that look the most profitable. However, that also means consolidating risk in those investments too. And, as everyone knows, the stock market can go up and down, and sometimes, it can collapse.

A non-diversified fund is at risk. A fall could set back an investment’s value for years while it, slowly, recovers. In extreme cases the fall can be so big recovery is impossible, and may even wipe out the value altogether.

An example is General Motors. It went, in just a few years, from being a reliable stock, paying a healthy dividend, to being worthless when the company went bankrupt. Although such situations are comparatively rare, they are not unheard of. An investor who had not diversified their investment would have seen its value wiped out.

Diversification is not just about individual stocks, either. It’s worth ensuring you diversify in multiple ways. Just as individual companies can crash, so can industry sectors. And, even then, occasionally whole markets fall. The 2008 financial crisis and the 2020 Covid-19 pandemic both saw the markets lose significant value. While that value returned, it took time. Having a diverse portfolio, whether that includes commodities, property, or even the humble savings account helps mitigate losses in bad times.

3.Golden Rules of Investment : Keep calm

‘Keep Calm and Carry On’ has become a cliché, but the advice remains good. The market, and along with it the value of your investment, is constantly moving. And most of the time it’s best not to watch it!

The daily movements of your stock may be interesting to watch, but the responses it generates in most people are not that useful. The flight or fight response might be good when you are in peril, but not when a stock moves a few pennies. Instead, you need to focus on the trend and avoid panicked decisions like dumping a falling stock or jumping on a rising one.

One of the problems of reacting like this is that you are almost always going to be late. The movement will have already happened, so you end up buying high or selling low, the opposite of what you want. And, generally, playing a longer game has benefits; most people who saw their portfolios lose money in the 2020 pandemic will already have more than recovered those losses.

For most investors, refraining from checking the value of their investment frequently is good advice, helping 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 temptation to top up — is a good technique and might turn you a nice profit.

Putting the golden rules of investment together

Patience is, perhaps, the foundation of the three golden rules. Compounding is powerful, but takes time to build that power. Keeping calm, often, means that you wait out market movements and, instead, rely on longer-term trends. And even diversification relies on this patience. When you review your portfolio, some parts will have better returns than others, but while you might have — with hindsight — been able to more money, more quickly, you have, effectively, exercised patience in return for more financial security.

The golden rules work, that’s why investor after investor will repeat them. Because they know investing takes time, but when you put that time in, you get the rewards.