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5 Investing Rules to Keep in Mind

November 13, 2020 · 6 minute read

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5 Investing Rules to Keep in Mind

It can be difficult trying to learn the rules of investing, because in reality, there are no hard and fast rules.

There’s nothing stopping someone from theoretically putting all their money into gold and burying it in the backyard, going all-in on a single penny stock, or buying nothing but bonds and never taking on any risk at all (all of which would probably be bad ideas, just in case you didn’t know).

Investing comes with risk, and being new to anything often involves making mistakes. Still, many common investing mistakes might be avoided by a simple review of some of the most well-known rules for investing.

In the long run, avoiding unnecessary losses could be seen as the main goal of following seasoned investment advice.

What to Know About Rules of Investing

There’s no simple road map to investing success, but there are some basic guidelines that have stood the test of time. These are principles that hold true for most people in most situations.

It’s up to individual investors to decide which rules make the most sense for them.

Here are five rules for investing that new investors might want to take into consideration.

Diversification

The main goal of diversification is to minimize risk. Diversifying a portfolio involves adding additional investments in an attempt to hedge against other investments.

When done well, this strategy can sometimes reduce risk by ensuring that whenever some investments go down, others go up, creating a balance that limits losses.

This can limit the gains a portfolio can expect in some cases, depending on the type and level of diversification (reducing risk often means reducing potential rewards), but it doesn’t have to.

There are two primary kinds of diversification.

•  Vertical diversification means investing in very different securities. Examples: investing in both domestic and international stocks or in retail stocks and gold.
•  Horizontal diversification refers to investing in different securities that are similar. An example would be investing in different types of bond funds or several different companies in a specific sector such as technology.

Of course, it takes a lot of time and effort for an investor to understand what he or she is doing, so it’s easy to argue that diversification can still work for many investors.

Dollar-Cost Averaging

As with diversification, the main goal of dollar-cost averaging is to reduce risk.

Dollar-cost averaging involves investing little by little over time.

Let’s say Alex has $1,000 she wants to invest. But she doesn’t want to invest all of the money at one time because the price could potentially see a big sudden drop.

So she devises a plan to invest in small batches at set intervals. She might buy $100 worth of assets each week, month, or quarter until she has the amount she wants.

Dollar-cost averaging in this manner, or “averaging in,” as it’s sometimes called, reduces exposure to volatility.

That means this investing rule helps protect investors from an asset’s price fluctuations. By spreading out buy orders, more of an asset will be purchased when its price has gone down, and less will be bought when the price has gone up.

Of course, fees must also be considered. If investors have to pay a $5 brokerage fee each time they make a transaction, this needs to be factored in when thinking about dollar-cost averaging.

While buying in tranches might reduce risk, paying more fees could result in a heavy burden for new investors working with small portfolios.

The more money being invested, the less of an effect fees should have.

Averaging in works well for long-term investors with low risk tolerance.

An Emergency Fund

Holding on to an emergency fund is perhaps one of the most basic and important rules of investing.

Depending on whom you ask, most experts recommend a savings cushion of four to six months’ worth of expenses. This way, investors can rest easy knowing that when something unexpected happens, they will be prepared.

According to a Federal Reserve survey, about 40% of the U.S. population could not afford a $400 emergency bill if it came up. And that was before the coronavirus pandemic of 2020 and associated economic shutdowns.

As investors worldwide have seen, unexpected things can happen at any time and without much notice. That’s why it’s important to have an emergency fund regardless of what the rest of an investor’s portfolio looks like.

Once an emergency fund has been established, it doesn’t all have to sit in cash. With inflation averaging 2% a year in most developed countries, holding cash in a checking account is guaranteed to lose at least 2% annually. Fortunately, there are some other options.

The simplest might be a high-yield savings account. Several lenders offer savings accounts that yield higher than average interest rates.

Another option might be a money market account. Money market accounts are similar to high-yield savings accounts in that they yield higher interest and have a set limit on the amount of withdrawals account holders can make each month. This type of account usually requires a larger minimum deposit but might allow for use of a debit card and check-writing.

Certificates of Deposit can also serve as emergency fund vehicles. CDs are a little different in that they require money to stay in the account for a specific period of time. In exchange, account holders receive a guaranteed return on their money.

Withdrawing from a CD before the maturation date will incur a penalty.

Dividend-Yielding Positions

Like saving for a rainy day, this is one of those logical rules of investing and should come as no surprise.
Simply put, whenever possible, it benefits investors to be holding positions that yield dividends. Dividends are a portion of a company’s profits that they promise to give to shareholders.

Dividend-yielding stocks and real estate investment trusts, or REITs, provide investors with income that they can either save, reinvest into the same security, or use to invest elsewhere. The amount of dividends earned is proportionate to the number of shares held.

One thing that makes dividends attractive is the power of compounding interest. By utilizing what’s known as a dividend reinvestment program, investors can choose to let any earned dividends be automatically reinvested into the same security.

This way, the next time a dividend payout comes around, an investor will hold slightly more shares, and will receive a larger dividend than the last time (assuming everything else remains equal).

While many stocks yield dividends, not all dividends are created equal. It’s not uncommon for companies to reduce their dividend payout or even halt it completely at times.

But there are some companies with a long track record of not only paying dividends but increasing them regularly. This group of elite dividend-yielding stocks are referred to as “dividend aristocrats”—stocks that have increased their dividend each year for 25 years or more.

All stocks carry some risk. Investors who take that risk can sometimes enjoy the benefits of receiving dividends in return.

Abiding the Ups and Downs

Market pullbacks are temporary (and not always bad). Of all the rules for investing online listed here, this one might be the most abstract. It’s not an actual strategy or action item but more of a general awareness that can help a lot when uncertain times hit.

When markets go down, it can feel like the world is ending. New investors might find themselves pondering questions like How can investments lose so much value so quickly? Will they ever go back up? What should I do?

During the crash of early 2020, for example, $3.4 trillion in wealth disappeared from the S&P 500 index alone in a single week. And that’s not counting all of the other markets around the world.

During that time, CNN’s Fear and Greed Index reached as low as 6 out of 100, measuring some of the most extreme fear that markets could possibly face by this metric.

It’s safe to assume that many investors began panic selling some of their stocks and ETFs, while some people and institutions found themselves with an urgent need for liquidity (cash), selling anything they could get their hands on.

Scenarios like this have happened before and may happen again.

While many people see their portfolios decline in value during a market downturn (known as a bear market), these events are not pure evil. They are a natural part of the business cycle.

Accepting bear markets as natural and inevitable can help investors to be better prepared for and less panicked during a selloff.

Using the Rules for Investing

Keep in mind that these are only five of countless investing rules. Creating an exhaustive list would be almost impossible, but the rules listed here among some of the most commonly discussed.
Think you have a grasp of the rules of investing?

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