Key investment principles

There are a number of key investment principles that have stood the test of time and are essential for all investors to understand.

The benefit of compounding returns 

This is the ability to earn returns on your returns that have been reinvested. Over time this has a snowball effect and over many years you can end up earning more of your returns from the reinvested returns than from your original investment. 

Risk and return are always linked

The link between risk and return is the most fundamental rule of investing. To potentially achieve higher returns, you must be prepared to accept higher risks. All investing involves risk and there are different types of risk, such as losing part or all of your money, not receiving the return you were expecting, or not being able to access your money when you need it. Another risk for many people is actually being unwilling to accept the risks and invest in the type of assets required to achieve their investment goals.

Diversify to reduce your risk

Spreading your money across a number of different investments and/or asset classes is known as diversification and is the simplest way to reduce risk. For example, investing in ten different companies carries a lower overall risk than investing in one, particularly if they are in different industries or countries. Different types of investments perform differently under various market conditions – so whatever your investment goals, appropriate diversification is very important. More on diversification.

Values can be volatile

The value of an investment may fluctuate to varying degrees. For example, the value of a stock tends to fluctuate greatly, while low-risk fixed income investments have historically been more stable. The greater the potential return, usually the greater the volatility, and therefore potential loss if you need to access your investment when its value may be down. One simple strategy to mitigate the effects of volatility is to invest regularly and benefit from dollar cost averaging. More on dollar cost averaging.

Time in the market

All investments need to be considered in the context of time. Some investments such as term deposits can only be accessed at the end of the specified period. Time is also important with more volatile investments such as shares, both in terms of entering and exiting the investment. The more volatile the investment, the greater the time required to ‘ride out’ any possible downturns in the investment’s value and maximise long-term returns.

Gearing can increase gains and losses

Gearing is investing using borrowed money. This has the potential to increase returns as well as losses. Borrowing money costs money, so to be worthwhile the total return (income and capital gain) needs to exceed the cost of borrowing the money and outweigh the risks of ‘losing’ the borrowed money that you will still have to pay back.

What’s next?

What's next?