The six principles of investing everyone should know

James McManus


read 4 min

The world of investing can be complex, but there are certain principles that can aid us all. Whether you have £1,000 or £1m to put to work, the following six principles will stand you in good stead.

Principle 1: Remember the trade-off between risk and return

Understanding risk and return is crucial to sound, sensible investing. That doesn’t mean you should take a low or high risk-and-return strategy; it’s all about settling on the level of risk you’re comfortable with.

Different types of investments have different levels of risk associated with them. Equities can be more high risk than bonds, for example. Emerging market equities tend to be riskier than developed market stocks. The higher the risk, the greater potential there is for higher return on your investment, though you must also understand that the value of your investment may go down as well as up.

Either way, investment portfolios, unlike savings accounts, are designed to experience volatility. When it comes to investments, volatility is a natural part of the investment journey and requires investors to exercise patience and a long-term mind set to ensure good investment outcomes.

Principle 2: Be diversified

It may be a somewhat overused idiom for investing, but the idea behind ‘not putting all your eggs in one basket’ still rings true. By investing in a diverse range of asset types, you can help spread your investment risk and improve your chances of benefiting from potential higher returns.

Another overused phrase perhaps, but diversification is frequently called “the only free lunch in investing”1 – and for good reason. The concept is simple: if you want to invest in the stock market, for example, then spread your risk across multiple companies, thus reducing your exposure to a concentrated bet that might wipe out your returns.

In a diversified investment portfolio, the less correlated the assets, the better. Again, the principle is quite simple. If you invest everything in one sector – let’s say technology – and that suddenly bottoms out, because of say a change in regulation around these companies, then a bulk of your investment goes with it.

Principle 3: Invest for the long-term

Jumping in and out of the market can lead to missed opportunities. Investing should be considered as a long-term game. We recommend three years at a minimum. Sudden losses can stir your emotional impulse to withdraw or suddenly change tack – no-one likes to see their portfolio go down in value – but staying put and resisting the temptation to tinker can pay off in the end.

Data on global developed market stocks going back over the last 50 years demonstrates that the probability of losing money on your investment goes down the longer you stay invested. The green line on the chart below, based on data from 1970 to 2021, shows the power of long-term investing in drastically reducing your chance of losses.

 

Source: Macrobond; MSCI World Equity Mid and MSCI Large Cap Total Return in GBP, 1 January 1972- November 2021 

Principle 4: Rebalance, re-invest 

Rebalancing is an investment management practice that ensures a portfolio stays aligned to its objectives. 

Over time, as the value of each holding in a portfolio rises or falls (because of market performance), that holding will come to represent a larger or smaller proportion of a portfolio.  

As a portfolio deviates from its original weightings, the risk of the portfolio changes too. And because higher-returning assets tend to be higher risk, over long periods your holdings in higherrisk investments are likely to become an ever-greater part of your portfolio, raising your risk level above your start-point. 

Rebalancing involves buying and selling assets within a portfolio to retain the right proportion, or ‘weighting’, of different assets in the portfolio, to match your original objectives. 

Principle 5: Keep costs in line with your investment approach 

Investment products can be ‘active’ or ‘passive’. Active funds try to beat the market – typically through an individual fund manager who picks stocks – while passive funds (such as the exchanged-traded funds that Nutmeg uses) aim to deliver the market return. Given the efficiency of markets, history suggests you’re much less likely to find an active manager that outperforms the market than one who underperforms. 

And at the same time, fees for active funds are typically much greater than those for passive funds, eating into your potential returns. Morningstar reports that the average fee for an active stock picking fund was 1.1% as at December 2020, whilst the average passive fund cost just 0.19%2. At Nutmeg, we aim to keep costs low and invest efficiently by using passive exchange traded funds in our portfolios. 

Principle 6: Use your tax-free allowances – ISAs, pensions and much more 

To help you get your finances in order and not pay more tax than necessary, make sure you’re making the most of the tax breaks provided by the Government. From maxing out your ISA allowance to reviewing your pension contributions, you can build up a significant portfolio of tax-efficient investments. 

Risk warning 

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance. Tax treatment depends on your individual circumstances and may be subject to change in the future 

Sources 

[1] The phrase was first coined in 1952 by Harry Markowitz, widely considered the father of modern portfolio theory. 

[2] Morningstar ‘How fund fees are falling’;, December 2020: How Fund Fees are Falling | Morningstar  

 

 

James McManus
James is chief investment officer at Nutmeg, having joined in 2015 from Coutts & Co. A self-confessed ETF geek, James is regularly quoted in the national and industry press and has been voted one of Private Asset Manager’s ‘Top 40 under 40’ in each of the last three years. James holds a BSc in International Business from Nottingham Business School, the CFA UK Investment Management Certificate, and the CFA Certificate in ESG Investing. He can be found tweeting @j_a_mcmanus

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