If you know nothing about investing, entering the investment world for the first time can be a daunting prospect. There are thousands of websites out there offering information, opinions, educational courses and tools to help streamline your investment process, not to mention the hundreds of investment books you can buy offline. The world of investing is a daunting place, and as the availability of information continues to improve, it is only going to get more complicated.
But I believe there is no need to overcomplicate any investment process. Sure, you can invest tens of thousands of dollars in a top trading platform, educational courses and hardware to improve your chances of beating the market. Although, as we’ve seen over the past few years, even the world’s best-funded hedge funds struggle to achieve market-beating returns year after year. It is much easier, and less stressful, to adopt a simple approach to investing.
If you want to take the simple investment route, there are really only two investment principles you need to understand before starting to invest your own money.
Simple principles
The first principle is probably the easiest to understand, but it is also an idea most first-time investors fail to grasp. Warren Buffett (Trades, Portfolio) has famously said the first rule of investing is not to lose money, and the second rule of investing is never to forget the first.
This is the most important principle of investing because this simple rule has much more to it than just avoiding losses. Put simply, Buffett is saying that to be a successful investor; you need to make sure every investment you make has a minimal risk of permanent capital impairment. Such a strategy would rule out investing in highly speculative mining stocks, early-stage venture capital-style business, companies reliant on capital markets for funding and profitable businesses and fad businesses in favor of buying blue-chip champions such as Coca-Cola (KO, Financial), American Express (AXP, Financial) and Wells Fargo (WFC, Financial). Even IBM (IBM, Financial) would qualify in this category as the risk of the company going to zero is relatively nonexistent -- even though group sales are falling, IBM is still generating around $17 billion per annum in cash from operations. A business generating this much money does not fail overnight.
Even taken to its extreme, the principle of not losing money will almost certainly ensure you are better off over the long term than those who disregard this crucial element. Buying an S&P 500 tracker fund returning an average of 9% per year would mean your returns are around three times higher than the average investor. Studies have shown the average investor achieves a return of around 3% per year.
When combined with principle number two, principle number one is extremely potent.
Growing over time
Principle number two is the idea of compounding, building up wealth steadily year after year with little or no effort. Compounding is a powerful tool, but the power of compounding can be destroyed in a second if you do not appreciate the first principle. For example, if you start off with $1,000 and invest these funds in an S&P 500 tracker fund achieving a return of 9% per annum for a decade, at the end of the period you will be sitting on a pot of $2,367, a gain of $1,367 with almost no effort on your part.
But if you took your $1,000 and invested in a highly speculative stock, which ends up costing you 50%, it will take you around 18 years of being invested in the S&P 500 -- with an average return of 9% per annum— to hit $2,367. If you work hard and can achieve a return of around 20% on your money, after the initial 50% loss, it will take nine years for the total to go back to around $2,500. Unfortunately, unless you are Buffett, these kind of returns are just impossible. So if you want to achieve maximum returns with minimal effort and low risk, a slow and steady way is the best.
Summary
Overall, to be a good investor you have to understand two simple principles of investing. Number one, do not lose money. Number two, the power of compounding. If you have a firm grasp of these two concepts, the chances of you underperforming are significantly reduced.
Disclosure: The author owns no stock mentioned.
