Four Golden Rules to Investing in Shares

Investing in the stock market is about building wealth, but achieving it takes more than picking stocks you think will rise.

Investors use all sorts of methods to decide where to put their money. Some rely on hot tips, professionals or stock-tipping reports. Others buy companies because they know their products, spend hours researching or simply hope for the best.

Let me say up front: this is not a sound way to build and manage a portfolio if you want to profit consistently. You need a process that helps you select suitable stocks, manage your capital and control your risk.

So, let's look at the four golden rules I use when investing in shares.

Start with your investment goals

Before deciding which stocks belong in your portfolio, you need to understand what you want your portfolio to achieve. Are you looking for growth, income or a combination of both?

Unfortunately, I would receive a myriad of answers, but rarely would anyone say the stock aligned with their investment goals. Most had taken a scattergun approach rather than considering whether the stock belonged in their portfolio.

What do you want your portfolio to achieve?

Your goals will be influenced by many things, including your income, family circumstances and current wealth. Before deciding how to invest your capital, ask yourself::

• How long do I want to invest for?
  
• How much money do I require to achieve my goals?
  
• What returns do I expect?
  
• What level of risk will I feel comfortable with?
  
• How much capital am I willing to risk for the opportunity to make higher returns
  

And most importantly, will what I decide to invest in allow me to sleep at night because it is far better to manage your investment risk rather than worrying about how your investments are performing? Particularly, if you choose to invest in stocks outside the top 150 by market capitalisation.

Why you need rules when investing in shares

If you were to invest $500,000 in an investment property right now, how much time would you spend researching the type of area and property you want to invest in in order to be confident you will get a good return? Your answer, no doubt, is probably a lot of time. 

Now let’s assume you want to invest $500,000 in one stock (this is not advisable). How much time would you invest in researching how to select the right stock so you invest your money wisely with the intent of achieving a return? Probably a considerable amount of time.

The amount we invest, however, tends to change our perception of the risk we are taking and the research required to manage that risk. It is usually easier to swallow a $1,000 mistake than if you make a mistake with $500,000. But whether you're investing $500,000 or $1,000, the process should be the same. Every investment deserves the same disciplined approach, since they both represent the same amount of risk.

Applying the golden rules to investing in shares

These are the four golden rules I apply when investing in shares. They provide a disciplined framework for selecting stocks, allocating capital and managing risk.

Golden rule #1

Irrespective of the amount of money you have to invest, you should always spend the same amount of time researching your options to ensure you are protecting your capital every time.

Golden rule #2

When constructing a medium to long-term portfolio, you should aim to hold between 5 and 12 stocks in your portfolio (if you are an active trader, you may want to have closer to 5). 

The idea is not to have lots of stocks with small amounts invested in each; instead, you only require a small number of the right stocks, with larger amounts invested in each. This actually lessens your risk and increases your returns because:

• Smaller portfolios are easier to manage and represent lower risk. The more stocks you have in your portfolio, the more work you need to do to manage your risk level.
  
• It is far easier to select a smaller number of stocks that are rising in price. The result is increased returns.
  
• You will have fewer transaction costs when buying and selling stocks because a smaller portfolio has less transactions.
  

Golden rule #3

Never invest more than 20 per cent of your total capital in any one stock. 

If you invest in the stock market, you need to accept that some stocks will fall in value. However, this rule helps reduce your exposure to risk while allowing you to achieve good returns. The point is, you want to minimise the amount of capital you could lose at any one time.

For example, if you invest $100,000 in five different stocks, you would invest $20,000 in each stock, or 20 per cent of your total capital. If, at the end of your first year, one of the stocks dropped by 50 per cent, you will have lost $10,000 of your initial capital.

But if the other four stocks have risen in value by 10 per cent, then you will have made $8,000.

Therefore, your total loss would be $2,000, or only 2 per cent of your total initial capital. In effect, you will have minimised your exposure to risk by spreading your capital across a number of stocks.

Golden rule #4

You should only ever invest 10 per cent of your available capital in trading short-term, highly leveraged markets and allocate the remaining 90 per cent to trading a medium-to-long-term portfolio. This is a very solid money management rule that allows you to take a low-risk approach with your money while still achieving good returns on your capital. 

The goal with this rule is to have the 10 per cent allocated to trading short-term highly leveraged markets achieve equal or better returns when compared to the 90 per cent. Let me explain.

Let’s say you have $150,000 to invest. You would place $135,000 in a medium-to-long-term portfolio and allocate the remaining $15,000 to short-term trading. Leveraging or trading on margin at 10:1, for example, you would have $150,000 to generate cash flow in your short-term trading account.

Now, let’s assume you need to make $50,000 in income per annum. If you averaged 11 per cent return on your medium-to-long-term portfolio of $135,000, including dividends, you would receive around $15,000. That means you only need to make approximately $35,000 from your short-term portfolio.

Managing your short-term watchlist

In my experience, when trading leveraged markets over the short term, your watchlist should consist of no more than 10 stocks that you know very well and you should hold no more than four leveraged positions to minimise your risk.

Therefore, you would place no more than $30,000 (20 per cent of the $150,000 in your short-term trading account) in each trade. That way, you have the remaining cash accessible in the event of a margin call. This occurs when a leveraged asset falls in value, requiring the debt to be reduced or additional security to be provided.

So there you have it: the four golden rules to investing in shares allow you to construct a profitable portfolio that can provide an income stream once you gain the required knowledge to trade in all market conditions.

Dale Gillham is one of Australia’s leading investment educators and the bestselling author of How to Beat the Managed Funds by 20% and the award-winning Accelerate Your Wealth: It’s Your Money, Your Choice. His books explore the principles behind managing money, investing directly in shares and developing the skills required to take greater responsibility for your financial future.