The world of stock investing can, admittedly, be an intimidating place for any beginner. Yet just like when we were scared of getting on a bicycle for the first time when we were young, once we get the hang of it there really isn’t anything to be scared of.
In fact, thinking of taking control of our personal finances by investing for our future can be likened to our first go on the bike.
And just like how we had training wheels to help us gain the confidence, we should have some set ground rules to follow before we start investing.
Although the financial industry likes to make out that investing is “complicated”, in reality it isn’t. Being a successful long-term investor tends to be quite straightforward but you need to have the basics right.
That means approaching investing with the right psychological mindset. In that vein, here are five golden rules that investors need to follow before they even think about starting to invest.
1. Have an emergency fund
For all individuals, one of the first things you need to do is ensure you have an “emergency fund” set aside for any unforeseen circumstances or expenses.
These funds could be used to cover expenses if you, say, were made redundant or you had a sizeable medical bill.
Typically, this emergency fund would be a minimum of six months’ worth of your living expenses. If you feel like you want to save more, you could expand this capital buffer to one year.
Why do you need to do this? Mainly because you don’t want to be forced to sell any of your investments in future when you need cash.
This phenomenon – called “forced selling” – can destroy the long-term returns of your investments.
Effectively, it’s because you could be forced to sell your stocks during a period when the market is falling, i.e. at exactly the wrong time.
Ensuring you have that buffer there so you can meet whatever expenses come your way is a crucial first step on your investing journey.
2. Never borrow to invest
Leverage. Debt. Loans. Whatever you want to call it, borrowing money to invest in stocks is a definite no-no.
This should be quite obvious to the majority of us but greed can also get the better of our psyches when we look at rising markets and stock prices.
However, if you invest, either through leveraging your account or taking out a loan, you are putting your financial health at risk.
That’s because markets can turn at any moment. If we all knew what markets were going to do next week, next month or next year, we’d all be rich.
Yet markets are unpredictable by nature. Trying to gain an upper hand by borrowing money, even if you think of investing that in dividend stocks to earn a return, is never a smart idea.
It’s a perceived shortcut to investment success when in fact, there are no shortcuts to investing successfully over the long term.
3. Try to hold your stocks for a minimum of five years
This relates back to point one. If you put money into the stock market, you should be prepared to leave it in there for years (if not decades).
The oft-cited quote from investing legend Warren Buffett can never be repeated too often. He once said that the ideal holding period for any investment of his was “forever”.
It’s well-known within the investment community that the longer you stay invested, the higher your chances of a positive return. Buying a stock and holding it for one day gives you a 50/50 probability of a positive return – basically a coin-flip.
However, stretch out that holding period to 20 years and the probability of you losing money plummets to 0%. Those are pretty good odds.
My rule of thumb is that before you buy a stock, be prepared to hold it for a minimum of five years. This will give you the time for your investment to grow and will prove to you the worth of long-term investing.
Ideally, you will want to leave your investments to compound your wealth over a decade or longer. But being mentally prepared to see where your initial investment is at after five years is a great starting point.
4. Accept that stock market volatility is normal
When Apple Inc’s (NASDAQ: AAPL) share price fell 30% over the space of a few months in late 2018, you’d be forgiven for thinking the iPhone maker had done something very wrong.
In fact, it was just a period where the US stock markets fell around 20% in the space of three months on fears of the brewing US-China trade war and the Federal Reserve raising interest rates.
However, nothing had actually fundamentally changed with Apple’s business throughout that time. It continued to churn out iPhones, iPads and AirPods on a massive scale.
It was still recording solid growth in its revenues and profits. Yet the stock market punished its shares. Why?
You hear a lot about “irrational exuberance” when financial talking heads opine about rising share prices but in fact, that irrationality also applies to stock markets when they’re falling.
We can’t control when markets rise or fall. But, as a rational investor, what we can do is control our emotions.
That means accepting that volatility in stock markets is part and parcel of long-term investing. Even better, it allows us to purchase shares of companies that we love at a discount – like finding a great deal when you go shopping!
Apple’s stock is a case in point. Following its 30% fall in 2018, the stock price was at US$37. Where is it today? At around US$115.
5. Don’t try to time the market
For professional or laymen investors alike, trying to time the market is a fool’s errand. You will never be able to “sell at the top and buy at the bottom”.
The sooner you can get used to that fact, the more comfortable you will be buying stocks and staying invested in them.
That’s because it takes time for your returns to compound. Even if you have bought a stock today and it falls 3-4% the next day, it’s meaningless in terms of the returns over a 10- or 20-year period.
In fact, being out of the market on some of the best days will severely impact your returns over the long term.
That’s because some of the best periods of stock market performance follow on from some of the worst days.
Taking the emotion out of investing by “buying and holding” is one of the best ways to ensure you can generate those big returns over the longer term.
That old adage that investing success is about “time in the market and not timing the market” is one of the most cited investment nuggets only because it’s so true.
One of the best ways to stay disciplined and avoid timing the market is to employ "dollar cost averaging" so that you invest a set amount into the market every month or, perhaps, every two weeks.