Warren Buffet, CEO of Berkshire Hathaway, has a famous saying:
Rule number one: never lose money
Rule number two: never forget rule number one
When making an investment there is always a chance that you could lose money. Warren Buffet has lost money on plenty of occasions, and will be the first to admit it, but he has made his fair share too ($90 billion as of January 2018). When investing you have to weigh up the risk against the reward. Low risk investments yield low returns but they are much safer and there is a very low chance of you losing money. At the other end of the spectrum you have investments which are very high risk but could yield amazing returns. There is of course a much greater chance that you could losing part or all of your capital (hence the high returns). Here are two examples:
UK Government Bonds: You can currently achieve a return of 1% – 2.2% on UK treasury backed bonds by NS&I, depending on the size of your investment and how long you invest for. This is about as safe an investment as you can get (in countries with stable economies). If you are not one for taking risks then this is probably where you want to be keeping most of your money.
Cryptocurrency: At the other end of the spectrum we have high risk investments. At the current time cryptocurrency is an investment which carries huge risk. The top cryptocurrencies, such as Bitcoin and Ethereum, have seen percentage price increases in the thousands. This has brought them mainstream attention and many people see it as a get rich quick opportunity. Whilst I believe blockchain technology has a lot to offer, investing in individual cryptocurrencies at the present time comes with huge risk. Furthermore, they do not generate a yield so it is more speculating than investing. An example of a high risk investment which does carry a yield is a high yield bond, also known as a junk bond (i.e. lending money to a company with a poor credit rating).
In between the low risk and high risk investments there is a whole range of different opportunities with varying risk /reward. With such a broad range, how do you go about trying to stick to Buffet’s number one rule?
A diversified portfolio will help protect you from volatility and risky investments. Let’s say you want to make a high risk investment, regardless of the risk. If you have £10,000 in savings and you risk it all on that one investment then you are heading for certain disaster. It may not happen right away but eventually you will take a big loss. For most investors, diversification is key for successful investing. Here is an example of how a diversified portfolio of £10,000 might look:
Cash = £1,500
Investment in low risk government bonds = £2,000
Investment in stocks* = £5,500
High risk investments = £1,000
*You can further diversify by spreading stock investments over various industries.
In the example above we have over a third of our savings in cash and low interest bonds, which will be yielding interest of 1% – 2%, may slightly more if you shop around. You can sleep knowing this money is safe and will be gaining a small amount of interest. Then we have just over half held in the stock market. Shares can obviously lose value too but if you are investing in companies which are in good financial health then you are most likely going to see gains over the long-term. In addition you may receive a share of the profits via dividends. Finally we have a small amount allocated to high risk investments. I’m not saying you should put money into high risk investments but if you are going to then it should be a small proportion of your overall portfolio.
Do your homework
If you are making an investment then you should have good reason to do so. Before investing in a company I go through the income statement, balance sheet and cash flow to check the financial health of the company. Whichever the investment method, make sure you carry out thorough research and are fully aware of the risks and the anticipated returns. Crowdfunding has become a popular way for start-ups to raise capital and many people are drawn to it hoping to invest in the next big thing. If you are going to participate in an investment like this there are lots of questions you should be asking. Are you getting a fair price? Is the company in good financial health? Has the company raised capital through crowdfunding before and if so how well was the money invested? Carrying out thorough research will result in far greater gains in the long run.
Investing is always risky but you are in control of the level of risk you take on. When investing look at the big picture and how individual investments affect your portfolio. If you lost £1,000 out of £10,000 it wouldn’t be the end of the world but how would you feel losing £7,000? By considering the worst case scenario you can prepare yourself for all eventualities and hopefully it will lead you to make wiser investments. If you are serious about investing then learn as much as you can about it. If you are happy making smaller returns through safer investments then by all means stick to that. You shouldn’t take on more risk if you are uncomfortable with it. However, you should try to ensure that your returns are greater than inflation (read my article on real interest rates here).
Remember….never forget rule number one!
Looking to start investing but don’t have much saved away? Check out How to invest with little money.