Five Rules of Investing in the Stock Market

Monday, 25th February 2019 11:58 - by Ranjeet Singh

The saying goes that there are many ways to skin a cat, and whilst we don’t advocate animal cruelty of any kind, this principle is a very valid one. It is also particularly applicable to stock market investing. In other words, there is no single right or wrong strategy that will consistently guarantee results - there are multiple strategies that can be equally effective.

However, and like most things in life, if you want to increase your chances of being successful, there are still a few key principles that you should follow. In this short report we detail what we believe are the 5 rules of investing. It is the master blueprint of share-dealing that all investors need to be aware of. Whether you are investing for the first time or you are an expert investor you need to know about how to tip the trading odds in your favour and we believe that if you follow these five rules you immediately put yourself into the elite 10% of investors who regularly win and jump out of the overwhelming group of 90% where investors regularly lose.

1. Investing is a Zero-Sum Game

The first rule of investing is to know that in order for you to make money, somebody has to lose money. It’s a zero-sum game which means that for every winner there has to be a loser. The reason that this principle is so important is because investors who fail to understand this concept, will not nearly be as successful because they are looking at the game of investing through the wrong lens.

Imagine you are an athlete at the Olympics and you didn’t realise that in order for you to win somebody had to lose. How would that affect your race? If you knew that only the first three positions would earn a medal would that motivate you to want to be in that top group? Of course, it would. The strategy, preparation, technique, execution – all of these things would change because you would understand your goal.

One of the biggest problems that investors face with the stock market is they don’t really know their goal and therefore their strategy from the outset is designed to fail. In a single word, the number one killer of financial success is ‘complacency’, and it’s easy to see why.

In the long term it’s possible for everybody to win; and this gives a false sense of security. People stop trying because they know that they can make money. So, the zero-sum game applies to the short term only which investors often avoid, but that is where most of the money is. In the long term, say 5 or 10 years, the stock market is NOT a zero-sum game and so more than one person can win. In fact, we can all win because over a longer period of time, the stock market always appreciates in value.

But you shouldn’t care only about the long term, you should be thinking about the short and medium term. If you want to consistently win at investing you need to learn to compete and not just to participate and that means winning when others are losing, not winning when everybody else is winning too.

2. The Return to Risk Ratio

The second guiding principle for investing is to know what the right level of return to risk ratio is for every investment that you hold. Now this one is an absolute killer because in the same way that the zero-sum concept is missed by most investors, so too is this ratio. We believe that it comes down to pain, or rather a lack of it.

When somebody feels pain or discomfort when they act in a particular way, it is human nature to stop the action which is causing that pain. Similarly, when there is no pain being felt, even if it is damaging, people carry on indefinitely. This is why smokers usually smoke for decades before they feel any pain. With the stock market it’s the same thing – because investors are making say 5% per annum they falsely assume that they are doing okay because they are earning a profit, however small. This is accentuated by the fact that they compare their rate of return against their cash savings in the bank which is earning a pitiful 0.1% and so relatively speaking they feel very happy about their investments.

The problem is that they are comparing apples with pears. The risk level of the investment has to be considered first and foremost and the return has to be appropriate to that risk. If you don’t know how to calculate your return to risk ratio you will eventually get found out.

3. Focus on the Downside, not the Upside

For generations we continue to see private investors make the same cardinal mistake of searching for the holy grail, whether that be to find the next penny stock that will reach a pound, or simply to find the next set of safe, dividend paying companies that will give them passive income for the rest of their days. This may come as a surprise but both of these approaches are flawed; that’s because there is no holy grail.

The stock market is a barometer for the economy and just as one has no control over the economy, nobody has control over the stock market; it is unpredictable. Of course, there are strategies and techniques that one can use to give them an edge but ultimately the safest, quickest and best way to be successful is simply to ignore the fatal error of trying to generate capital and income. If the market is going up and in a bullish trend then unless you get very unlucky, there is a very good chance that you will make money. Sure, one portfolio may make slightly more than another but in a rising market you don’t need to be a genius to be successful.

It’s the same with the property market or any other market – it moves in cycles and during the good times you will make money without doing very much at all.

Your focus should therefore be on preserving your capital and thinking of ways to reduce your risk. The good news is that there are plenty of ways to do this; from building a short fund, CFDs or spread-betting, buying put options or inverse tracker funds. Any one of these products will be a far more effective way for you to not only preserve your capital but to also increase performance. The two are inextricably linked.

In fact, a recent study that we conducted showed that it was possible to improve the performance of an average portfolio by as much as 50% simply by eliminating the 25% worst performers of that same portfolio.

The secret to successful investing is simply not to lose money. Do that successfully and you will make money.

4. It pays to be Contrarian

This is one of the most difficult things to do but if you can master this, you will be ahead of 95% of the rest of the investor population. That’s because the majority of growth in any market is at the start and end of the cycle. Think back to the financial crash of 2008.

Many investors lost up to 40% of their portfolio wealth during that time and those who invested in banking shares lost considerably more. Have you ever thought about where all of this money went? Money doesn’t just disappear – it simply gets passed from one person to another. In other words, some people made a lot of money during this time, including most of the traders at Goldman Sachs who bet on the stock market crashing.

Similarly, if you look at the stock market during 2009 you will see a very sharp recovery in prices. In fact, some companies doubled in price during this time. Imagine making 100% on your investment within a 12-month window. The tails of the Stock Market Distribution Curve (SDC) is where the majority of the movement is and where the greatest opportunity lies and it’s where contrarians make their money while everybody else is still busy licking their wounds.

It’s not easy to be contrarian because it means that you are going against what everybody seems to think is logical and reasonable, but if you can master this skill set and apply it to the stock market you will immediately put yourself into the elite 5% of traders in the world. The good news is that even if you get it wrong, you are not risking very much at all. Bizarrely enough it is one of those odd situations where you can potentially earn a very high return for a very low amount of risk - that’s right, you actually end up with a great return to risk ratio (strategy 2).

5. Invest Smart, Not Hard

The final piece of the investment jigsaw puzzle is to be smart when you invest. The saying goes that there is ‘no fool like a busy fool’ and nowhere is this statement more accurate than in the investment world. It is not unusual for private investors to spend days, weeks, months and even years looking at the stock market, speaking to advisors, reading newspapers, researching funds, searching online and so on. Dare we say it, you may find yourself in this very trap yourself and hence why you are reading this article – because you are looking for that nugget of information to make yourself rich.

Well, let us free you from those shackles with a piece of advice that will save you a lot of time and expense.

There is a huge amount of money that is being wasted when it comes to investing which should be in your pockets and not in those who sit between you and your investment. For example, financial advisors, advisory brokers, fund managers, market makers, execution platforms and HMRC are all taking money from your portfolio. Some of these fees may be necessary but most are not. The trick is to reduce the number of layers between you and the golden pot.

Along the way you will have a stream of paper-shufflers who will want to get their hands on your hard-earned cash but you really need to consider if they are giving you value for money. Some undoubtedly will but most won’t.

Knowing when to invest, how to invest and who to invest with, is a quick and simple fix to immediately improving the performance of your portfolio. The next time that you look at your portfolio and find that it is underperforming relative to the benchmark index, take a moment to look at the inefficiencies and see if there are inherent structural deficiencies which are holding you back.

The richest person in the village is very rarely the one who works the hardest, he just knows something that most of the others don’t.

So that’s an investment wrap. Follow these 5 core principles and you will have an immediate head start on your competitors and the best foundations for future success.

Good luck.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.