Investing for the long term: four principles for prudent investing

Most people don't invest because they simply enjoy investing. Instead, they're trying to achieve a financial goal, such as securing a retirement income, building up a fund to pay school or university costs for children, or getting together the means to start a business, or many other reasons. So their main aim is to grow their wealth over the long term.

Unfortunately, many investors go about this the wrong way. Some think they need to hunt for outsize gains as fast as possible. So they look for excitement leaping from one hot sector to the next: from emerging markets to commodities to biotech. Others are deeply suspicious of the stockmarket they see it as a lottery where everything could vanish overnight. Every time the market drops, they must fight the temptation to sell everything.

Neither of these mind-sets is likely to deliver good results. Successful investing should be neither exciting nor nerve-wracking, but rather more mundane. It's about taking a very long-term view, trying to earn steady gains rather than stellar profits, having a clear plan and not worrying too much about the bumps along the way. This is easier said then done, but here are four principles that will help you along the way.

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Stay diversified

Many investors don't diversify their portfolios across different investments. They end up investing exclusively in shares sometimes just a few UK companies. That's a mistake, because it means they're taking far more risk than they should. It certainly makes sense for most investors to have a substantial amount of their money in shares, because over the long term the stockmarket has outperformed most other investments. But shares have also been relatively volatile. They have had a lot more ups and downs, including times when they have fallen by 40% or more during a single year.

Holding some safer assets, such as cash and the safest government bonds, can help to reduce volatility. Even for young investors, who are investing for the distant future and can afford to take plenty of risk, this can be a smart move. It's easier to sleep at night if your portfolio is less volatile and makes it less likely that you'll be panicked into selling up at just the wrong time. Older investors, who have less time to recover from major setbacks, should consider keeping a larger proportion of their wealth in safer assets.

The ideal split between riskier and safer investments will depend on your circumstances. But 60% riskier and 40% safer is the standard rule of thumb for a medium-risk portfolio. Use that as a starting point and adjust according to how much volatility you can stomach.

Keep your costs down

Markets are unpredictable we can't control what returns we'll get. But we can control the amount we lose to costs such as trading fees. So keeping costs down is always an important part of earning better investment returns. Today, when potential returns from most investments look lower than they have been in the past, minimising costs is more important than ever.

What can we do to keep a lid on costs? First, make sure you don't trade too much. Excessive trading adds costs and also hurts returns: there's plenty of evidence showing that most investors would do better if they traded less rather than more. Next, make sure that the fees your stockbroker or fund supermarket charges aren't excessive. That doesn't mean that you should always go with the rock-bottom cheapest provider good service is often worth paying for. But there are plenty of providers who charge high fees for an unremarkable service.

Lastly, while we may not always think of taxes as a "cost", they eat into your returns in just the same way. So aim to invest in a tax-efficient way for example, by using your Isa allowance and pension contributions as much as possible.

If you invest in funds, you should also apply the same scrutiny to fund managers' fees. The average managed fund charges a fee of around 0.75% and the cost is much higher when other expenses are taken into account. Yet countless studies show the average fund underperforms the market, meaning that they're being paid to underperform a simple passive fund (a fund that just tracks the market). We believe that there are managers who can beat the market over the long term, but identifying them in advance isn't easy and they're a small minority in the industry. So your starting point should always be a passive fund, such as an exchange-traded fund or index fund, which have low costs (often less than 0.25% per year). Only choose to use a managed fund if you have a very compelling reason to do so.

Rebalance regularly

Even if you start with a well-diversified portfolio, the amount you have in each investment will change over time because some will perform better than others. So it's important to rebalance at regular intervals, by selling a bit of those that have done well and buying those that have not. Otherwise you'll end up with more that you want in assets that have recently risen strongly and may be at greater risk of falling back.

However, you don't want to rebalance too often because it pushes up costs. Rebalancing once a year is a sensible compromise and timing it to coincide with the start of the new tax year is often a good idea. This way, you may be able to use new money you pay into your Isa to rebalance the portfolio, by buying more of those investments where you hold too little.

Don't ignore inflation

One of our biggest flaws is "money illusion" thinking about returns in nominal terms (ignoring inflation). If an investor makes a profit of 10% over three years while the stockmarket has only returned 7%, they may feel they've done well. But if inflation is running at 3.5% per year, they've lost almost 1% in real (inflation-adjusted) terms. If you want to grow your investments to give yourself a good standard of living, you need to focus on earning an adequate return over inflation.

The simple way to invest

These principles may sound obvious but how should a novice investor put them into practice? If you're keen to manage your own portfolio and to learn more about investing, you could begin by reading some of the books on page 16 for information on constructing a portfolio. You may also be interested in MoneyWeek's Lifetime Wealth newsletter, which provides a model portfolio of exchange-traded (ETFs) and index funds. Alternatively, if you'd prefer a very simple solution, consider the range of LifeStrategy funds from Vanguard (Vanguard.co.uk). These are well-diversified index funds, split between stocks and bonds in different proportions depending on how much risk you want to take (from 100% shares to 80% bonds/20% stocks). They are cheap (ongoing expenses of 0.24% per year) and you can buy them through most good fund supermarkets, so they're a solid choice for someone who wants to invest regularly in a portfolio without too much hassle.