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Seven Key Principles for Investing

June 21, 2012 | Comments: 0 | Views: 139

Whether you are starting out as a beginner investor or an experienced investor, one thing is for sure. You need to think as an investor. Investing is not for everyone, simply because an investor need to own a certain package of temperament. In other words, it is the way an investor think that makes him a true investor, instead of a gambler. Here in this article, you will find seven key principles for investing which I have personally consolidated for sharing with my readers, in hope of educating the less-informed and challenging my understanding. What better way to sharpen one's thought in learning than by teaching, right?

As a quick summary of what I am about to expound on, these are the seven key points for you to take away:

  1. Circle of Competence
  2. Independent Thinking
  3. Delayed Gratification
  4. Intrinsic Value
  5. Margin of Safety
  6. Secret of Compounding
  7. Relative Thinking

While it could be argued that these principles are non-exhaustive and I might be over-simplifying things, I wish to reiterate that this article is meant for the less informed to accelerate their financial education. They are derived from my learning experience. Sometimes, less is more.

1. Circle of Competence

Simply put, what I do not understand, I do not do. If I were to be interested in something I lack understanding in, I should go and learn about it before diving into doing the activity. You see, risk comes from the lack of control, and the lack of control comes from the lack of knowledge. As described by Warren Buffett, one of the world's greatest value investors, says "Diversification is protection against ignorance." To avoid ignorance, get knowledge.

2. Independent Thinking

Charlie Munger, a multi-billionaire and business partner of Warren Buffett always emphasizes the importance of inverse thinking. He quoted, "Tell me where I would die so I would not go there" as a way of covering as many possibilities in any investing opportunity. Nobody can predict the future. Insight into the future is not as hard to acquire as foresight into the future. Basically, as investors, we need to think for ourselves because ultimately, we are individually responsible over the stewardship of the money in our own pockets. To think independently, avoid herd mentality. Stop guessing or assuming; start finding out facts instead of dwelling in opinions.

3. Delayed Gratification

This is often one of the most misunderstood concepts, so I will spend a little bit more effort to elaborate on this. The key word here is patience. Let me repeat myself, the ke word here is patience. One more time. Patience.

Let me be up-front here. Most people will have a difficult time to absorb what I am about to say. Please bear with me and later on, you will realize how counter-culture this principle is. This is why for the few who truly apply this principle alone, they are the rich, and for the remaining majority, they are the poor.

Emotional Quotient (EQ) is more important than Intelligence Quotient (IQ) in this case. Let me remind us that it is your individual temperament that separates you from being an investor or not. The rich and the poor have a certain pattern of behavior when it comes to money. For one, the rich alway apply the "Pay Yourself First" principle. They treat savings as an expense. Every time they earn, they first save, then they spend. The poor, however, tend to earn, spend, and then save the remaining.

The other habit that sets the poor from the rich is the ability to invest more than they spend. An investor understands that money used for investing should also be treated as an expense. That is, they are ready to lose the money they've put into investments. Hence, they only invest when they are sure they will have an unfair advantage of winning. And when they do invest, they always look out for opportunities to make their money work for them.

4. Intrinsic Value

Investors are less of a speculators, and more of an analyst. For all investment opportunities, there is a need to discover the true value you believe it to be. The more ascertain you are of the real value, the more accurate you will be able to judge if it is a worthwhile investment. You see, no matter how financially rich you are, there is always a limit to your capital. You have to make do with what you have to get the most out of the moment of opportunity.

The question to ask is: what is the worth of this opportunity?

A quick tip is to know that it is better to be roughly right than to be deadly wrong in determining the intrinsic value. Avoid being penny-wise, but pound-foolish.

5. Margin of Safety (MoS)

This point is best illustrated with an example. Say, for example, you found a public listed company with durable competitive advantage. You like the stock because it has a strong business model and a powerful management team with integrity. The have a track record of success, but the price on the stock exchange is overvalued at the moment. Would you buy the shares? A savvy investor would adhere to the famous Rule Number One of Warren Buffett:

Do not lose money.

Recalling that what you invest is what you're ready to lose, you won't want to throw away your money foolishly. Since you know how to measure the intrinsic value, you know that you can afford to wait till the price is undervalued before putting in the money. This is to factor in any misjudgment you made in determining the intrinsic value. An example is to purchase something that is worth the value of $1 at the price of 60 cents. Look out for such a kind of deals.

By the way, there is a Rule Number Two, and it goes, "Remember Rule Number One."

6. Secret of Compounding

The rich knows the secret to being rich is to save AND invest. They also know that with control, you can harness the power of compounding. Compounding is a friend to the rich, but a foe to the poor. It makes the rich richer and the poor poorer. It exists in inflation and in the return of interest (ROI).

A $100 saved today with an annual inflation rate of 5% would become around $60 of today's value 10 years down the road. On the other hand, a $100 invested with an annual return of the same 5% will become around $160 in 10 years' time.

Try calculating it yourself. Think about the time value of money.

7. Relative Thinking

A true investor is shrewd. You think in terms of percentage, and not just the absolute. You'll be more concerned over the return of investment more than the return of interest. Because the percentage holds more weight than the absolute figures, you have the special ability to see what is a more worthwhile investment. If you're starting out to invest and you have little capital, this is especially useful. Let's say we have two investment opportunities, such as those below:

Project A: $100 investment with $10 return per period

Project B: $10,000 investment with $100 return per period

At first glance, one might feel that Project B has a higher ROI and seem more attractive than Project A. However, at a deeper analysis, you'd have realized that Project A returns 10% but Project B returns only a measly 1%. If you want to make your money work for you, wouldn't you look for more investment opportunities such as Project A?

So there you have it. These are seven guiding principles to help you to become a better investor. Investing is simple, but not easy. It takes discipline. It is knowledge-intensive and capital-intensive. I wish you all the best in your investing journey. And when you do make money, remember to give back. This world needs more rich people, people who thinks like the rich.

Peter Low is a writer/blogger who specializes on down-to-earth ideas for growing money. You can check out his website at Low Han Yew Peter where he provides unreserved education on improving personal financial IQ, including topics such as Think Relative Over Absolute Numbers, Farming and Investing, and Asset and Liability.

Source: EzineArticles
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