Investing basics: Follow these 7 principles

Most investors, even experienced ones, do not operate by a series of guiding principles. As a result, they will sometimes overreact or make decisions that run counter to their instincts and their best interests.

The starting point for successful investing is self-discipline. And to achieve that, you must have a well-defined set of standards from which to work.
Here are my seven basic principles for investing success.

Principle One: Establish an objective. What are your investing goals? Growth? Income? Tax advantages? Some combination? You must be clear in your mind what you wish to achieve or you cannot choose the proper securities for your needs.

Principle Two: Keep things simple. Don’t run before you can walk. If you do, you’re almost sure to fall flat on your face.

Frequently when I’m a guest on a telephone hot line show I’ll get a call from someone who says something like: “I don’t know a lot about investing and I’ve just bought some shares in Moose Pasture United Mutual Fund. What can you tell me about it?”

Forgive my bluntness, but what a stupid question to ask! The caller has just bought a diamond a Cairo bazaar and now wants to know if it’s real.

There’s a golden rule when it comes to investing:

  • If you don’t understand it, don’t put your money into it.
It’s so basic, yet it’s violated all the time-often by people who would never dream of spending a few hundred dollars on a new appliance without investigating it thoroughly and satisfying themselves they were getting the best possible deal.

Making an investment is like buying something. It’s strictly caveat emptor-let the buyer beware. There aren’t as many high-pressure sales types in the business as there used to be, but there are still some around. Don’t give in to them.

Principle Three: Start small. Don’t get in over your head before you know what you’re doing. When you’re ready to begin investing, pick something that doesn’t require a large cash outlay and get a feel for the process.

A great many people decided they wanted to plunge into high-tech stocks in late 1999 and early 2000 when Nasdaq was going through the roof. They were swept up in the excitement of the moment and invested far more money than they could afford. When Nasdaq tanked in the spring, many lost heavily. If they’d started small, they would have escaped relatively unscathed.
Principle Four: Use borrowed money with caution. There are certain ways in which borrowing can be a useful tool in building personal wealth. Taking a mortgage on a property is one; borrowing to maximize an RRSP contribution is another. But using borrowed money to buy a portfolio of stocks or mutual funds can be very risky. Be sure you understand all the implications before you act.

Principle Five: Look at the Tax Consequences. Tax rates have come down a lot in recent years. But the top marginal rates are still in the forty to fifty percent range depending on where you live. That can eat away your investment profits pretty quickly unless you take steps to prevent that.

Your first move is to tax shelter as much money as you can. An RRSP is the obvious starting point; maximize your contributions to it before you look elsewhere.

Paying down your mortgage is another basic tax shelter. Mortgage interest is not tax deductible so the less you pay, the more you free up in after-tax income. As well, your personal residence is not subject to capital gains tax.

Beyond that, look for tax-advantaged securities. Now that the capital gains inclusion rate has been lowered to fifty percent, capital gains are again a highly tax-efficient way to make investment income.

Dividend income also receives a tax advantage, as does income from some royalty income trusts, REITs and the like.

Principle Six: Remember that prices don’t always go up. Just ask anyone who invested in the Nasdaq Composite Index in February or early March of 2000. In one terrible week in April, the index fell twenty-five percent in five trading days!

Under the right (or, more correctly, the wrong) circumstances, anything can drop in value. Hold that thought in the back of your mind at all times.

Final principle: Begin. That may sound simple, but many people never get started. They have great intentions, but they keep putting things off. Next month they’ll get going. But next month something comes up.

If you’re determined to start a program, then do it! Don’t make excuses for waiting. That’s a game for smokers who don’t really want to quit. I don’t care if it’s only five dollars a month-the  important thing is to get into the habit of putting some money aside. Once you start you’ll find it’s not as difficult as you thought. And you’ll find it easier to add a little more to the wealth-building program whenever your household income goes up.

Adapted from the book 6 Steps to $1 Million by Gordon Pape, published by Prentice Hall Canada.