The six principles of investing everyone should know

James McManus


3 min read

The world of investment management can be complex, but there are certain investing principles that can aid any aspirational investor. Whether you have £1,000 or £1 million to invest, 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 tend to have different levels of risk associated with them. Stocks  can be more high risk than bonds, for example. Emerging market stocks 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 your friend.

Principle 2: Be diversified

By not putting all your eggs in one basket, and by investing in a diverse range of asset types, you can help spread your investment risk and improve your chances of benefiting from potential investment returns.

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 put all your eggs in one basket – let’s say the pharmaceuticals market – and that market suddenly bottoms out, all your eggs go with it.

Principle 3: Invest for the long-term

Jumping in and out of the market can lead to missed opportunities.

Investing is widely considered to be 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 2020, 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 1970- January 2020

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 higher risk investments are likely to become an ever-greater part of your portfolio, raising your risk level above where you started from.

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 objectives.

Principle 5: Keep costs in line with your investment approach

Investment can be active or passive. Active funds try to beat the market while passive funds (such as exchanged-traded funds) aim to deliver the market return. You’re much less likely to find an active manager that outperforms the market than one who underperforms it.

The typical charge for an active fund is around 1% a year, while passive funds charge an average fee of 0.6%2. For comparison, the Total Expense Ratio (TER) in the European ETF industry is between 0.1 and 0.25%, as of March 20203.

Read more: Intelligent ETF trading – six ways Nutmeg beats competitors

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. A stocks and shares ISA may not be right for everyone and tax rules may change in the future. If you are unsure if an ISA is the right choice for you, please seek independent financial advice.

Sources

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

[2] Refinitiv data for the FTSE 100, 250 and All Share total return indexes, which includes dividends

[3] MSCI Europe Index (EUR) March 31, 2020

[4] Lipper at Refinitiv, Review of the European ETF Market – 2018

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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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