3 Cardinal rules of investing

Here are three simple rules to help you become rich by investing in the stock market.

Rule 1: Compound

Albert Einstein is said to have called compound interest “the eighth wonder of the world”. The reason for his enchantment is the simple fact that each time an investor’s wealth increases in value, it will then grow from a larger base.

This means the returns from successful investing tends to resemble an upward curve over time rather than a straight line. It’s human nature to think in straight lines and overlook curves.

Stock market returns are not stable, however, over time the principle of compounding still applies. Returns from stocks and shares also tend to be higher in the long-term than returns from most other assets.

The 30-year compound annual growth rate from the MSCI World index to the end of 2020 was 9.7 percent measured in sterling. That would have turned £1,000 into £16,000, although, the effect of inflation means the buying power of that money would be equivalent to about £6,400 at 1990 prices. 

There were many stock market ups and downs over these 30 years. This means the stock market is not a place to put money you know you’ll need in the near future. But for the long-term, to start getting rich from stocks and shares waste no time in getting saving, getting invested, and getting compounding. 

And don’t bother trying to time it. There is no evidence that there is any reliable way to do this, although there is plenty of evidence to suggest we all think we can do it.

The incredible power of compounding can also work against investors. This is why it is so important to keep costs as  low as possible, even when considering seemingly tiddly factions of a percent. Read our comparison of investment platform costs here.

Rule 2: Diversify

Big stock-market falls are relatively infrequent but are nevertheless a fact of life. Such falls are also very unpredictable. Investors need to both expect big falls to happen and accept them when they do. 

Importantly, this means constructing a portfolio that can survive a severe downturn. 

If a portfolio’s value collapses significantly, then it may be impossible to ever recover. This can easily happen with investments in individual stocks and even individual markets, as well as with “leveraged” investments, such options or using borrowed money to buy stocks “on margin”. 

To make sure your investments will live to see another day after a market collapse, it is important to diversify by spreading risk across many dissimilar investments. Significant leverage should be avoided. 

Diversifying a portfolio does not necessarily mean having lots of different holdings. And risk can be very concentrated in portfolios with many holdings should all of the investments have similar characteristics - i.e. they’re all shares in emerging-technology companies. 

The very easiest way to diversify in stocks and shares is to simply buy a low-cost global index fund.

Rule 3: Don’t stress

There’s a lot of evidence from the field behavioural psychology to suggest we are all emotionally programmed to do the wrong things with our investments at times of stress.

Being a rocket scientist or brain surgeon won’t help you either. Smart people are often particularly prone to make bad investment decisions due to their ability to stand up arguments founded on base, emotional desires. Sir Issac Newton famously lost a huge amount of money speculating on South Sea bubble stocks, which prompted his comment that he “could calculate the motions of the heavenly stars, but not the madness of people”. 

Markets sometimes fall sharply and you will see your wealth plummet. Historically such falls have only ever been temporary setbacks for diversified portfolios, though. Sometimes dangerously volatile investments will make your friends and acquaintances rich (again, often only temporarily) and you’ll be tempted to join in; so-called fear of missing out (FOMO). 

Don’t let yourself be panicked out of good investments or tempted into dangerous speculation. In the stock market, it is much better to get richer slowly than risking it all with rash decisions. 

As we’ve  already seen, the basic principles of becoming rich by investing in stocks are relatively straightforward: compound and diversify. For most people, it is the emotional allure of bad choices that is the biggest obstacle to achieving this. 

When one thinks about it, It is not surprising that it's emotionally tough to be a good investor. It is a pursuit that on the one hand is hugely stressful and on the other is deftly boring. Watching the value of your wealth plummet when markets fall is stomach churning. Meanwhile compounding works over time frames that make its immensely powerful effects tedious and almost imperceptible to observe. 

Still, for those focused on the long-term, the ends are definitely worth the means.