The 6 Basic Principles of Successful Investing

You really don't need to have a graduate degree in finance to enjoy success in your investing endeavors. Simple, basic knowledge is a powerful tool. The purpose in becoming familiar with these fundamental investing concepts is to remove fear from your decision-making process. Once you have a grasp of the way they operate, you'll be able to take a more active, informed role in the direction of your portfolio and, ultimately, your financial future.

Diversification - Simply, diversification means not putting all of your eggs in one basket. If one investment bottoms out, you haven't lost everything. Since stocks respond differently to changes in the economy and the marketplace, a short-term decline in one can be balanced by others in your portfolio which are currently stable or rising in value. The key, then, is not necessarily the number of assets that you own, but the tendency of those holdings to not move in concert with each other.

Asset Class Investing - Each basic asset class -- stocks, bonds, and cash investments – has specific risk- and return characteristics. Stocks can be grouped and evaluated according to their capitalization and whether they perform as growth or value assets. For instance, small capitalization companies are generally newer, faster-growing organizations that consequently carry higher risk than larger-cap companies, which tend to be more established, well-known, and have steadier streams of income and profits. Bonds are most commonly evaluated by their length of maturity and quality of the borrower.

Asset Allocation - Asset allocation refers to the way that investment funds are divided among the three basic asset classes – stocks, bonds, and cash investments – in order to increase expected risk-adjusted returns. The goal is to combine percentages of investments in different asset classes to maximize your portfolio's growth for the amount of risk that you're willing to take in that area. Asset allocation can also be applied to narrower segments of each of the basic classes. Stocks, for example, can be further divided according to growth, value, small or large cap, domestic, or foreign. As a broad group, stocks have the highest average total return over the long run, but are usually the most volatile over short periods of time. Cash equivalents are the least volatile, but have the lowest return. Bond volatility falls between the two.

Rebalancing - The purpose of rebalancing is to maintain the same percentages in the various asset classes in order to preserve proper diversification during all market conditions. Rebalancing is necessary because the inevitable up and down moves of the market invariably change allocation percentages. For example, some short-term gains might be forfeited by rebalancing your portfolio, but large losses can also be avoided.

Compounding - Compounding is the process of earning interest on money that's invested, and reinvesting those earnings into the same investment. The concept is that at the end of each year, interest is earned not only on your original principal, but on all of the previously accumulated interest as well; in other words, earning interest on interest, which is a very powerful investment mechanism.

Time - Given enough time, investments which might otherwise seem of little value can become quite attractive. The longer the period of time you hold an investment, the closer the actual returns will approach to the expected average. In other words, short-term fluctuations will even out. Analyses have shown that the trade-off between risk and reward is driven by time. With a long-term view, you're better able to make investment choices which have a greater chance for success.

In Part 2 of this series we'll examine two of the least effective investment strategies.

blog comments powered by Disqus
Scottrade