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Basic Investment Principles
Establishing realistic financial goals is an essential first step towards successful investing. Understanding investments that are best suited to help achieve your goals is equally important.
Investment principles guide you in your investment choices. Following these time-tested investment principles enable you to build a strong foundation of financial security.
Top Principles:
Rupee-Cost Averaging
A systematic approach to long-term investing is called rupee-cost averaging. This refers to the practice of investing the same amount of money in the same investment vehicle at regular intervals, regardless of market conditions. If the investor takes the rupee-cost averaging approach, the amount invested is always the same. Thus, the investor automatically buys more shares when the price is low and fewer when the price is high.
The investor's natural instinct might be to stop investing if the price starts to drop but history suggests that the best time to invest may be when you are getting good value. Rupee-cost averaging can be an effective strategy with funds or stocks that can have sharp ups and downs, because it gives more opportunities to purchase shares less expensively.
The benefit of this approach is that, over time, you may reduce the risk of having shares with the highest cost price. Instead, as the example below demonstrates, the average cost of your shares will be lower.
However, rupee-cost averaging does not assure a profit and it does not protect against investment losses in declining markets.
Compounding
Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
Through compounding, a small amount of money over time can grow into a substantial sum. Investments can increase in value over time - and the longer the time frame, the greater the value. This is achieved through returns that are earned, but not spent. When the return is reinvested, investor earns a return on the return and a return on that return and so on. Therefore it is important to start saving early in order to benefit from the power of compounding returns.
Diversification
Diversification is a strategy that can be neatly summed up by the timeless adage "Don't put all your eggs in one basket." In other words, your funds are spread over a variety of investment instruments. It is a risk-management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
For example, diversification could mean that you own several stocks, but they all come from various types of industries or different parts of the world. By having a variety of different stocks, your funds are more protected. If a certain company is badly hit, you will have other stocks that may be able to "take up the slack."
Asset Allocation
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. These asset categories have different risk-return characteristics, so if you have them in your portfolio, their different patterns of behavior offset each other. For instance, while one asset category increases in value, another may be decreasing or not increasing as much.
Asset allocation aims to balance risk and reward by apportioning a portfolio's assets according to your investment objectives, your risk tolerance and your investment horizon.
Asset allocation is generally the most important factor in determining the return on your investments. In fact, according to many researches and studies, asset allocation determines approximately 90% of the return. The remaining 10% of the return is determined by which particular investments (stock, bond, mutual fund, etc.) you select and when you decide to buy them.
Rebalancing
Rebalancing your mutual fund portfolio on a regular basis maintains the desired asset allocation in your investment strategy. Basically, rebalancing is bringing portfolio back to original asset allocation mix. This is necessary because over time some of the investments may become out of alignment with the investment goals, as investments don't all move the same way at the same time. Some will grow faster than others. By rebalancing your portfolio, you will ensure that you stick to original plans and have the kind of discipline that leads to long-term success.
For example, let's say it is determined that stock investments should represent 60% of portfolio. But after a recent stock market increase, stock investments represent 80% of portfolio. You will need to either sell some of stock investments or purchase investments from an under-weighted asset category in order to reestablish original asset allocation mix.
Rebalancing can be based either on the calendar or on the investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when investor should consider rebalancing.
Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that investor has identified in advance. The advantage of this method is that investments will tell you when to rebalance.