Basic rules of investing

Many ordinary people dislike the idea of investing in the stock market and it's not hard to see why. Over the past 15 years we've seen constant negative headlines. We've witnessed two huge market crashes, with the end of the tech bubble in 1999 and the recent financial crisis of 2008. Both resulted in almost a 50% decline in the UK stock market. Every few months we hear of another story of companies blowing up. The latest examples are Tesco, Balfour Beatty and Quindell, and there have also been the Madoff and Enron fraud scandals!

It's not surprising that most people view the market as a risky gamble which may or may not pay off. Why bother with the hassle and the sleepless nights? Moreover how on earth does one start investing? There are thousands of potential stocks to choose from in the UK alone. What makes a good one and a bad one? When should you invest? How much should you invest?

Why You Should Consider Investing in the Stock Market

Despite the negative headlines, the stock market has made excellent returns throughout history. Many companies are very good at making money for their investors. Even over the past ten years, the main UK stock market has returned over 100%, when you include dividends. Go back 25 years and the main UK market is up 668% and mid-cap (or medium-sized companies) are up 1,310%!*

Another reason you should consider stocks is that cash interest rates are so low. Almost all UK cash interest rates are below the rate of inflation, meaning your savings are effectively losing you money.

For the most part our stock market works well and a smaller investor has the same rights for every share as a billionaire does. Investing is also not nearly as hard as you might think. Anyone can do it, and be successful, as long as they understand a few basic principles. Investing in the stock market is also a great way of improving your own financial education. It's a vital skill, which is under taught in schools, but important for us all.

Basic Rules of Investing

1. Pay off any high interest debt such as credit cards or bank loans before you even consider investing. This is a golden rule. There's no point investing when you're paying huge interest on debts.

2. Don't be put off if you only have a small amount to invest. You don't need £20,000+ to start investing. At Chelsea you can invest with as little £50 and our fee is based on a percentage of your assets (0.6% a year) so charges aren't prohibitive. Even making a small investment will get you in the habit of saving and following it will help you to build up your financial knowledge.

3. The number one rule of investing is to diversify. This simply means, don't put all your eggs in one basket. A classic investing mistake is when an investor puts all their money in a single stock, only for them to lose all their money when the stock crashes. By investing in a fund which makes many different investments, you immediately diversify and protect yourself. You can also diversify by region, company size and asset class.

4. Don't have all your investments in the UK. Consider other parts of the developed world like the US, Europe and maybe also Asia and emerging markets if you have a higher risk tolerance.

5. You also don't have to have all your money invested in the stock market. Consider bonds as well. Bonds are money which is lent to governments, corporations and municipalities in return for periodic interest payments. They have typically given a lower return, but they are generally much less volatile than stocks and even more importantly they often do well when equities are doing badly. Commercial property funds are another way to diversify, although be aware that all funds carry some risk of capital loss.

6. Don't try and pick stocks. Don't buy individual stocks, even if you hear a great tip from a mate in the pub! Choosing stocks which will beat the overall market is hard and requires a huge amount of time, energy and experience. Remember if you're buying an individual stock you're saying you know more than all the other professional investors in the market.

When you start investing you should buy a fund. A fund invests in a range of different stocks, so it immediately covers our first point of being diversified. If one or two stocks in the fund go bust you won't lose all your money. There are two types of fund, passive and active. Passive funds simply try and match the entire performance of a stock market as best they can. Active funds employ a fund manager who actively takes positions and tries to beat the market.

It's much easier to research a fund than it is a stock. Websites such as provide a list of managers who have historically been skilful, as well as performance data and free research on their favourite funds. As you become a more experienced investor you may decide to invest in individual stocks but you shouldn't if you're a beginner.      

7. Consider your goal and you're investment time horizon. If your saving for a housing deposit and plan to buy in the next couple of years then investing in the stock market is probably not appropriate because a big fall in the market might prevent you from reaching your goal. The key point to remember is that the longer your time horizon the better chance you have of making money in the stock market. If you're going to be investing for over 10 years you should consider some exposure to the stock market.

8. Monthly Investing - You don't have to invest all your money at once. One of the best ways to start is by investing monthly. By investing monthly you can invest gradually, enabling you to take advantage when prices fall. Putting a fixed amount into a fund every month, regardless of market behaviour, is known as 'pound-cost averaging'. Monthly investing promotes the discipline of saving, whereby a small amount invested every month over several years can build into a sizeable nest egg.

9. Risk Tolerance – Never Panic - Consider your own risk tolerance and be honest. Some people just can't handle the swings of the stock market and it causes them sleepless nights. If you're one of these people you shouldn't be investing in stocks. Be aware that the stock market will almost certainly go through a major crash in the future but it's impossible to know when. Prepare yourself for this before you invest. Unfortunately many smaller investors sell out at the bottom of the market after a big sell-off and miss out on the subsequent rally. That's exactly what you want to avoid. Remember that you don't have to have all your money invested in stocks. Consider investing in bonds and other assets as well, to cushion any big losses.  

10. Don't Trade Your funds - there's a big difference between a trader and an investor. Don't pay too much attention to noise in the media. Beginners should not trade their investments. This can be expensive and is usually pointless. A wise man once said that the stock market is a very efficient mechanism of transferring money from the impatient to the patient. Choose your initial funds carefully and then review them every so often. Once every six months should be enough.

11. Stay Onshore
Check a fund's underlying investments on the factsheet. The Madoff scandal happened because no one bothered to check what he was actually doing. Beginner investors may want to check that their fund is an onshore fund. An onshore fund protects you in cases of fraud to the value of £50,000 per fund group. Of course this doesn't mean you're protected if the value of the fund's investments fall.

12. Charges
Charges matter and unfortunately many providers aren’t transparent. At Chelsea we only have our service charge (0.4% a year) and a Cofunds platform charge (0.2% a year). There are no other charges for anything else. Watch out for providers who take a minimum monthly charge or charge you for each transaction. There's no point in investing £100 a month if there's a minimum charge of £8 a month or if it costs £5 for each trade.

Also watch out for the charges of the actual funds. Look at the OCF (ongoing charge figure) which includes the (annual management charge). An OCF of greater than 1% is very high and should be avoided in most cases.

Be aware that the stock market is volatile. Understand the risks, but don't be scared off by negative headlines. Work out if investing in the stock market is appropriate for you. Remember to diversify your holdings and avoid paying too much in charges.

By James Yardley, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.

*Source FE Analytics 20/11/1989-20/11/2014

Published on 27/11/2014