Pay Attention to the Rules of Investing

Physician's Money Digest, October15 2004, Volume 11, Issue 19

Doctors know that the commonsense rules of health care (eg,regular exercise, balancedmeals, and periodic checkups)can mean the difference between life anddeath. The common sense rules of investingare just as crucial to the life of yourfinancial portfolio. To avoid financialruin and emotional havoc, subscribe tothe following rules of investing:

Bottom

line:

•Take responsibility. Whether we'retalking about physical or fiscal health,the same edict applies: Take responsibilityfor your own actions. In addition tothis edict, there is the cardinal rule ofinvestment self-defense: Never relinquishcontrol of your account to anyone. Ofcourse, that doesn't mean that youshould avoid seeking advice; on the contrary,it compels you to stay informed,do your homework, read, study, and askquestions. Ask questions even if theymake you appear uninformed. Asking questions is the only way tobe sure you know exactly what you'regetting into.

•Play the cynic. Ask pertinent questionsuntil you run out of questions toask. You might not like some of theanswers, but a negative answer up front,before your money leaves your pocket,is better than sitting in silence whileyour money disappears.

If you work with a broker or financialplanner, the onus is on you to establishregular communication. This doesn'tmean calling them once a year; it meanscalling them often, but never less thanonce a quarter. This is not a social call.You're calling to discuss your finances,review your portfolio, and update yourfinancial condition. The proper investmentfor yesterday could very well turnout to be the wrong one for today.

•Get a second opinion. Don't beafraid to get a second opinion when itcomes to your quarterly review or anyrecommendations your broker makes.Your financial health deserves the sameprotocol as your physical health. You'llbe amazed how much you can learn bysimply asking questions and obtaining asecond opinion from someone who hasnothing to gain by delivering honestanswers. For example, your accountantmight be a good person to talk to, or youcan seek guidance from another financialplanner or broker.

•Identify risk before counting profit.The truth is, every investment has somedegree of risk. Therefore, you should attemptto identify and understand the riskinvolved in any investment. It is veryimportant that the amount you are willingto risk is far less than the amount youare trying to gain. Why? Because no oneis perfect. You are bound to have investmentsturn sour; they might not havebeen poor investments when you madethem, but they just happened to turn outthat way. A potential return that is fargreater than your potential loss uses therisk/reward ratio to your advantage.

•Employ stop-loss orders. After youhave decided how much, if any, you canafford to lose, determine your maximumnegative return point (ie, the maximumprice decline you can sustain before youreach your capital loss limit). For example,if you buy 1000 shares of ABC stockat $10 a share and have decided beforehandthat the most you can afford to loseis $2000, your negative return point isanything less than $8. That's because ifthe stock dips below $8 a share, you'lllose more than your agreed upon limit.Once the loss limit is established, enter astop-loss order, if allowed, at that price.And no matter how painful, never changeyour loss limit once it has been established—don't budge.

•Diversify your portfolio. The simplestand most effective method to avoida financial wipeout is to diversify yourportfolio. This will substantially alleviatethe possibility of an economic catastrophebefalling you. By spreading the riskacross a broad spectrum of assets, youcan protect yourself from the wide swingsthat exist in all marketplaces. Because it'sreally a hedge against unknown economicconditions, diversification involvesmore than owning a wide range of oneparticular asset type.

While no two portfolios will be thesame, a well-diversified portfolio generallyincludes stocks, bonds, real estate,CDs, savings accounts, cash, and possiblyforeign currencies (assuming thatthey fit your personal financial profile).In other words, you're not putting all ofyour eggs in one basket, which is somethinginvestors should never do. Since noone can predict the future, you need tobe prepared for both the highs and lows.For example, in times of deflation, portionsof your assets will go down, whileother portions will maintain their purchasingpower. Of course, in times ofinflation, those portions of your portfoliobest suited to profit from an inflationarytrend will increase.

And you don't have to be rich tospread the risk. Many people mistakenlybelieve that diversification is limited tothe very wealthy, but that's not true. Allinvestors should diversify. The only problemwith diversification is that when youreduce the potential for risk, you alsoreduce the potential for reward.

Unfortunately, the concept of wealthwithout risk simply isn't true. As withlove and marriage, you can't have onewithout the other. However, when itcomes to investing, diversification is amust.