After more than 20 years in equity-fund management and financial markets, Saleem Khokhar, the head of equities at National Bank of Abu Dhabi, says he's seen a lot of mistakes made by investors when they park their money in stocks. Although financial markets can provide handsome returns over the long term, Mr Khokhar says investors can succumb to irrational behaviour, which can compound their losses and destroy the value of their investments. Even professional investors are not immune to falling markets. However, he says they tend to take a more balanced and disciplined approach - and take into account a range of variables that include growth prospects, valuations, correlations and volatility to optimise their returns. Here's his top 10 rules on investing in stocks.
1 Establish a financial risk profile
As a first step, many investors need to understand their own financial risk profile. While this may seem a simple first step, it is very common for investors to be seduced into inappropriate investments. Investors need to ask themselves simple questions. What is my investment time horizon? What is my targeted annual return from investing in the financial markets? Do I require regular income, capital appreciation or both? The answer to these questions are critical and dictate a number of factors that fundamentally influence the type of investment that is suitable. The risk profile of an investor should dictate exposure to differing asset classes such as stocks, bonds and commodities.
2 Understand the fundamentals
It is important to understand the fundamentals of the company and the market in which you are investing. Taking it to the most simplistic level, investors would have to ask themselves the following question: do I understand the business model in which a company is involved? Further, do I understand how the company actually makes money? Answering this question properly usually opens a Pandora's box of even more questions that relate to the industry the company operates in, its peer group comparisons and its growth prospects.
3 Investors must follow a disciplined investment approach
All too often, investors allow deep losses to accumulate without taking corrective action. All the while, they take profits at the earliest opportunity. In comparison, most professional investors will target a two-to-one ratio of profit to loss.
4 Only invest what you can afford to lose
Many investors who use leverage - or borrowed capital - to enhance returns fail to appreciate the extent of capital erosion on their portfolios as markets fall. This can lead to extreme stress when the extent of losses becomes apparent.
5 Avoid the herd mentality, the hot tip and the latest fad
History is littered with examples of asset-price bubbles, from Dutch tulips to technology stocks. The greater fool theory fully applies to this: asset prices will only continue to rise if someone else is willing to pay a higher price.
6 Avoid excessive trading
Excessive trading can, over time, eat into profits. It is worth remembering that active trading is better suited to the professional investor, who has the systems and resources to constantly monitor stock markets.
7 Diversify your risks
In a world that is becoming ever more correlated, it is becoming increasingly important to hold a range of investments. For the average investor, stocks, bonds, cash, commodities and real estate should all be considered for a portfolio that is constructed to match your risk profile.
8 Do not let emotions cloud your judgement
Fear and greed are the worst emotions to feel when investing. It is worth keeping them in check.
9 Respect and understand the power of compounding
Compounding is a technique that is used to generate earnings from previous earnings by reinvesting them. So investing a 12 per cent return per annum, for instance, equates to doubling your money every six years.
10 Invest steadily and progressively
It is very difficult to time the markets, so a steady, progressive approach should be followed.