This week Dominic Picarda looks at what might be considerd the most important rule of investment.
Don't Put All Your Eggs In One Basket
This is the most basic, and most important rule of investment. In the long run, the best way to possibly earn healthy returns and limit risk is to spread your holdings across a variety of assets, like shares from different countries, bonds, commodities, currencies and real estate. When one of these is doing badly, the chances are that another will be doing well, giving you a smoother ride over time.
Doubling Up
Spreading your risk isn't only a good idea when you're buying and holding for the long haul - it could help you make profits and avoid losses when you're trading too. You should be wary of doing trades that are simply doubling up your existing exposure. For example, the UK's FTSE 100 and America's Dow Jones move closely together. So, simultaneous "buy" bets on these two indices may effectively be one big bet on the same trend.
It isn't just stock markets that tend to rise and fall in unison. Say you entered a buy bet on Germany's DAX index and also bet on the Pound to rise against the US dollar. On the face of it, these are two different positions. But as the chart shows, the German stock market (black line) and the sterling/dollar exchange-rate (red) have generally done the same thing over the past year or so.
The Relationship
The simplest way to spot these relationships is with the naked eye. All you need to do is compare one instrument to another and look at the way they interact. Of course, such relationships often change over time. But there are many trends that have existed for decades and always seem to reappear even if they fade for a while. Oil, gold and other commodities often rise when the US Dollar falls, and vice versa. And government bonds often rally at times of bad news about the economy, while shares fall.
The Strategy
A possible strategy to balance out your risks is to find two assets that move together and buy one and sell the other. For example, say you're bearish about shares and open a "sell" bet on the FTSE. In case you're wrong, though, you could also sell the long gilt future, a bet that probably would pay off if the FTSE rises instead of falling.
Until next week, happy trading
The Tradefair Spreads Team
The above comments do not constitute investment advice and neither Tradefair Spreads nor Clean Financial accept any responsibility for any use that may be made of them.
Risk Warning:
Spread bets carry a high level of risk so you should only speculate with money you can afford to lose. You can lose more than your initial deposit and stake. Before you open an account, please ensure that spread betting matches your investment objectives, familiarise yourself with the risks involved and if necessary seek independent advice.
Article provided / approved by Tradefair Spreads which is a trading name of London Capital Group Ltd which is authorised and regulated by the Financial Services Authority (FSA), FSA Register number 182110.
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'Trading and the Most Important Investment Rule' edited by DB, updated 20-Aug-09
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