Investing your money in shares is one of the wisest things you can do. However, many people wonder how they can make the most profit for the money they invest. The purpose of this article therefore is to describe the principles that have proven to be the most important for making huge returns.
Before you invest a single dollar, think about the following questions:
- What is my goal?
- What type of person am I?
- How long have I got?
The first question will be the hardest to answer. The second and third question can be rephrased as: Do you want a reliable income stream or are you looking for huge capital gains? And: Do you need access to the invest money in 5, 10 or 20 years?
Be honest about what sort of person you are. Investing does not only require money to spend in order to succeed, but also personal characteristics such as patience and discipline. For example, if you have a busy job and therefore unable to study the various options there are, stick to simple products and systems.
The relation between risk and return
Most successful people on the stock exchange boast about their returns. Some exports report that there portfolio is full of ‘ten-baggers’, shares that have risen tenfold. However, these people are extraordinarily talented or just lucky. Don’t expect to make these sorts of returns if you are just starting out. One of the most important principles in investing is the relation between risk and return. If you do not have extraordinary talent for investing, you cannot expect to make high returns if you take low risks all the time.
Four types of risk
When investing your money, there are four types of risk you have to be concerned about. These are the following:
For example, if the company you invested in becomes insolvent and doesn’t pay any interest.
Your particular investment decreases in performance, because the whole market for similar assets performs worse.
This entails that an intermediary such as an agent or stock broker becomes insolvent or simply ceases trading.
If you investment does rise in value, but the inflation rate increases with a higher speed. In this way the overall worth of your investment is eroded in real terms.
This concept is often described with the following sentence:
“Don’t put all your eggs in one basket.”
Many people have ruined themselves throughout history by investing too much of their financial wealth in one category of assets. Real diversification can be described as investing in different asset classes that are not tightly related to each other.
In asset markets, the equivalent of compound interest is income reinvestment. This can vary from bond interest payments or paid dividends by companies. If you can invest in an asset that increases its return every year, by increasing its dividend, then the effect will be magnified further.
Many people think that if their investment rises in value, they automatically become wealthier. However, these people fail to take into account that there are various external forces that can lower or higher your real return. These are:
- Account management costs.
Taxation and account management costs can be influenced to a certain extent, while you can do nothing against inflation. You can avoid lowering real returns because of inflation by investing in things such as gold and National Savings certificates.