When you are first learning how to invest, you will quickly come to realize that there are two different ways to approach investing, Active and Passive investing. Active investing involves trying to specifically identify various stocks and other assets that markets have sincerely undervalued and have the potential for growth. Passive investing involves trying to adhere to a specific set of principles that can generally produce an above average return.
Generally speaking, most financial advisers would likely suggest trying to take a passive approach to investing. Being a passive investor does not mean that are you never willing to take risks. Rather, it means that the risks that you do take will be based on a general assumption about the market rather than faith in a specific asset.
Though it may possible to beat the market, developing a strong set of reliable principles is often the best way to begin investing. By assuming the role of a passive investor, you can avoid the risks inherent to investing in a single asset.
This article will briefly consider the most important principles for a new investor to consider. These principles can help add objective value to your portfolio and put you in a position to succeed.
Remember the Importance of Diversification
Anyone who has worked in finance will surely tell you that diversification is among the most important principles in the entire industry. No matter what your specific financial goals may be, diversifying your portfolio can help you immediately decrease your exposure to risk.
In fact, risk is usually viewed by those in the industry as having two fundamental components. Some of the risk inherent to your portfolio is tied to the market as a whole and is simply unavoidable. But some of the risk that can be seen in most portfolios is often referred to as something that can be “diversified away.”
The principle of diversification can have a very wide range of applications. Generally speaking, a diverse portfolio is one that will be composed of multiple different types of assets.
For example, a well-diversified portfolio will likely possess bonds, stocks, retirement assets, real estate, and even cryptocurrencies. This way, even if a particular asset crashes (such as what happened with real estate in 2007), your portfolio will only lose a portion of its overall value.
In addition to diversifying the asset classes you are currently investing in, it is also generally a good idea to diversify within a given class. This means that if you are going to invest in real estate, you may want to begin investing in multiple different locations. If you are going to invest in stocks, bonds, or international currencies, you should put your money in multiple different types as well.
Even the cryptocurrency market will give you multiple opportunities for diversification with thousands of different options including Bitcoin, Ether, and XRP. If you would like someone else to handle the bulk of the diversification for you, then you may want to consider investing in a hedge fund or mutual fund.
Though these funds may require a considerable amount of cash to access, their ability to pool resources together can help extend the benefits of diversity. Investing in an index fund—such as the S&P 500—is another great way to minimize risk.
It is better to Invest in Industries than it is to Invest in Companies
As stated, most financial advisers would probably advise against a strategy that is overly reliant on “betting” on an individual company. Unless you have access to some type of insider knowledge (which may be illegal to act on), having a “hunch” that a company is going to do well is usually not enough to justify investing.
If it does seem that a particular company is undervalued, you should ask yourself why. Why has the market incorrectly valued this company? Is the market wrong or am I?
In order to decrease your exposure to risk, it is often a good idea to invest in specific industries rather than individual companies. For example, doing something such as shorting stock in automobile manufacturers following the announcement of steel tariffs may help you earn a return.
If the fed announces rate changes, investing in the finance industry may also be justifiable. But even in these examples, the return you earn on your investment comes from knowledge of general industries, rather than faith in one particular asset.
Learning How to Invest Requires Patience
One of the primary problems with investing is that many people have unrealistic expectations. They imagine various Wolf of Wall Street type situations where they become rich overnight and this mindset can often be quite dangerous.
It is important to remember that within the financial industry, earning an 8% annual return on your portfolio is something that is generally considered good. This means that even a savvy investor who puts down $100 today will still only have $108 one year from now.
Many amateur investors will tend to overact and drain what little gains they’ve made in broker’s fees and transaction fees. In fact, the cost of trading is usually one of the main reasons why taking a passive approach to investing makes the most sense.
Paying $15 for the three transactions it took to earn $16 will totally skew your cost-benefit calculations. By having the patience to wait for your investments to grow, you will already have begun to functionally increase your rate of return. Though turning $100 into $108 may not initially be that exciting, accumulating value over multiple years will eventually pay off.
Learning how to invest can be an incredibly difficult challenge. If you are like most new investors, you are probably very eager to get started and begin making money. Fortunately, entering the world of investing does not require nearly as much initial resources as it once did in the past.
However, the need for having ample patience and well-founded principles still persists. If you are able to effectively diversify your portfolio, understand the merits of being a “passive” investor, and carefully calculate your risks, you will certainly be moving in a positive direction.