The 7 Golden Rules of Investing

Understand the object of your investment

As an investor, you should only invest in things that you understand. This doesn’t mean you should only invest in industries of your expertise. However, an investor needs to understand how an investment functions. When investing in companies you should quickly understand how the business model of the company works and how it will generate revenue in the future. To do this, you need to be able to break down the business model to the basic ratio.

For example, while logistics companies are concerned with storage and transport costs, e-commerce companies are dependent on the size of the shopping cart and the conversion rate. It’s the same with financial products: you should be able to quickly grasp how the product works. The financial market doesn’t bear advantages for complicated investments. Instead, the risk of making wrong decisions due to a lack of knowledge increases. So if you don't understand how a financial product works or how a company generates revenue, keep your hands off it.

Invest long-term

Investments should be made while keeping the long run in mind. Investors who are only out for short-term profits run the risk of losing their patience when exchange rates fluctuate and thus make high losses. Moreover, the performance of the portfolio sinks every time that an investor rejects a position and adds a new one. Instead, investors should invest in assets that they want to keep long-term.

Investor legend Warren Buffet once said that the optimal holding period for shares is “forever.” A contributing factor for this is the long-term use of the compound interest effect. The longer the investment horizon, the greater the potential compound interest effect on the initial value of the investment. This effect adds interest income from investments to the original asset value and, in turn, interest is paid on it too. In the short term, the compound interest effect hardly makes a difference to earnings, but in the long-term, it can have a significant impact. If an investor regularly reinvests his or her investment amounts, he or she can take advantage of this effect. 

Pay attention to valuations

One key figure is especially important to investors: valuation. The company valuation plays a key role in the question of whether or not the investment is lucrative particularly in enterprise participation. Investors don’t want to pay more for the earnings of a company and its future growth prospects than necessary. There are many different ways to calculate the value of a company. You can use detailed financial figures to calculate the company value of listed companies by looking at the development of the company in recent years. Based on this, you can derive a realistic forecast of how the company could develop in the near future. In venture capital, i. e. startup investments, company valuations are subject to a wider range of fluctuations, as there are often no reliable financial figures. But here too, there are methods for determining the company value. This value is a direct indicator of whether and how much an investor should invest in a company.

Calculate real return

Ultimately, the return is the decisive figure by which an investor chooses whether or not an investment is lucrative for him or her. The focus here should always be the real return, i.e. the return adjusted for inflation, transaction costs, and taxes. Nominal return can cause confusion because only real return can express the increase in purchasing power without alteration.

Private investors often underestimate how quickly a currency loses purchasing power within the span of a few years. Investment experts, on the other hand, are aware of inflation and clear the return of their investments of inflationary effects. Otherwise, they might overlook the way inflation eats up the returns over several years, potentially making the return on an investment that looked lucrative at first negative in the end. Tax effects and transaction fees are also excluded from the real return, since they also reduce the returns of an investment, but must be included in the calculation of direct costs.

Pay attention to timing and position size

Investors need patience. After identifying a good investment, the next step is waiting for the right time to get involved. Sometimes that can be right then and there, other times it can be months or even years later. But when the time comes, one has to be ready for it. Don’t jump on the next best opportunity; the market offers enough chances. When an opportunity is presented, the next question is how high the stakes are.

Many investors make the mistake of putting in the largest sum possible in a worthwhile investment. Instead, the size of a position should always correlate with potential return and the respective risks entailed. There are a number of ways to calculate the correct size of a position.

Don’t trust trends

Following the masses is not good advice for an investor. By the time even the last investor has heard of a worthwhile investment opportunity, the expected profit margin will already have become very low. Investment legend Warren Buffet once said: “I will explain how you can become rich. Be nervous when others are greedy. And be greedy when others are nervous.” Psychological effects play an important role in financial markets.

Accordingly, caution is advised in times where the market is booming. On the other hand, investors should not panic in times of crises but rather start thinking about advantageous purchasing opportunities. During those times, many organizations are undervalued, despite demonstrating a solid business model and generating profits. A successful investor tries to make rational decisions at all times and should neither blindly run after dominating trends, nor make investments just because the masses reject them.

Diversify Risks

Investors should never place their capital in only one single asset. Instead, the portfolio’s risk should be spread as widely as possible by investing in assets from different sectors and with varying risk/return ratios. This approach is called diversification.

This is an investment strategy designed to reduce the risk in the entire portfolio. A diversified portfolio contains investments that have the lowest possible correlation with each other. In the event of a crisis, this means that not all investments lose value at the same time. For example, you should not place your entire capital into biotech stocks, because in the event of an industry crisis, the whole portfolio loses value.

Instead, invest in equities from different sectors of the economy that are as independent of each other as possible. In addition, diversification should also be carried out across asset classes. This means investing not only in equities and equity funds but also in index funds, precious metals, call money, and bonds.

Did we pique your interest in investing in startups? Then register on Companisto today and stay up to date on all things concerning investments!