Three basic rules for investment success

Long-term investment success comes down to some basic rules. Here are three of the most important.

1. Start early

Compound interest is "the eighth wonder of the world", says Erin Burt on Kiplinger.com. As the Motley Fool points out, two ingredients are required for compounding to work its magic plenty of time and a decent return. For example, invest £100 a month from the age of 20, earning interest at 3% a year (tax-free if you are saving using an individual savings account, or Isa), and by the time you're 30 you'll have a pot worth £14,009. That's because the interest you earn each year also earns interest for every subsequent year, provided you leave it in the account.

Leave that £100 a month invested until you turn 40 and you get £32,912. But if you're able to earn, say, 7.5% a year before tax (just below the average long-term return from US equities), that £100 a month invested aged 20 creates a pot worth £135,587 aged 40, rising to £304,272 aged 60. So, lesson one is think long-term. But how do you boost your chances of getting 7.5% a year?

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2. Keep it cheap

Let's say you invest in a unit trust that gives an average return of 5% a year before charges on your £100 monthly investment. Stay invested between the ages of 20 and 60 and you'll have a pot worth just over £150,000. But let's say the fund you've chosen charges a fairly typical 1.5% a year in fees (before any other upfront or exit charges). Take those into account and your £150,000 ends up around £105,000. That's why you should pay attention to charges. In most cases, we would avoid unit trusts where possible and invest instead using investment trusts (which are listed on the stock exchange and have lower annual charges). Better yet, pick an exchange-traded fund (ETF), which will allow you to track the performance of a sector or index at a fraction of the cost of a unit trust.

3. Keep it simple

The clich suggests you should cut risk by not putting all your eggs in one basket. But you should also avoid spreading yourself too wide. The FT points to a study by James Norton of Evolve Financial Planning, which suggests that if you'd split your assets 60/40 between the FTSE All-Share and the Citi Bond index between 1988 and 2008, you'd have earned 8.83% a year. Widen that to eight asset classes and this rises to 9.91% for very little extra risk. But beyond that, you add very little extra return for a lot more risk.

Worse, those all-important charges rise the more asset classes you add, especially if you dabble in obscure assets, such as private equity, hedge funds, or fine wines. Indeed, US analyst Rob Arnott reckons "most of the advantage of diversifying happens with three of four seriously cheap asset classes". So you're better to get a decent level of exposure to a small group of assets that represent good value, rather than trying to get a little bit of exposure to every asset class going.

How the City gets ahead of you

Banking profits and bonuses are back with a vengeance. Astute trading, in the wake of the sharp recovery in the FTSE 100 since March, has helped City traders return to the black. But so have the following three investment tools, currently being investigated by global regulators, which give professional investors an advantage over the average private investor.

Dark pools

Share trades can take place on regulated exchanges, such as the London and New York Stock Exchanges, but plenty don't. These are done off-exchange, or 'over-the-counter'. They include broker-owned, unregulated 'liquidity pools', where deals can be done for large volumes at better prices than are available on public exchanges. But only those who know about them and have the software to access them get to use them.

High frequency trading (HFT)

Goldman Sachs recently disclosed that it had 46 '$100m trading days' in the second quarter of 2009. That, says Martin Hutchinson on investmentU.com, is "a record number".

HFT helps explain why. Fast, algorithmic (mathematical) programs help traders in effect to front-run the market get a buy or sell order in on a stock, basket of stocks, index or pretty much anything else, before everyone else buys or sells without alerting them. That lets those with the best software spot, test and then trade the short-term direction of the market, creaming off profits in the process.

Flash trades

Flash trading gives another advantage to those with the fastest share-trading systems. As Sean O'Malley, a partner at Goodwin Proctor LLP, tells Bloomberg: "computer-based trading can do things in a split second that no human could have done".

So, for example, investment banks or hedge funds can 'flash' their interest in buying or selling large numbers of shares at potential counterparties operating on a target stock exchange. They then get deals done milli-seconds before anyone else (often brokers acting for retail clients) can get a look in.

What can you do about this?

Nothing. That's a regulator's job. But these tricks help to explain why, at times of stress, markets can suddenly become volatile or illiquid (difficult to trade). They also explain why retail investors rarely get the best deals.