Basic Principles of Investing

Basic Principles of Investing

At first glance, investing can seem complicated. However, if you understand the basic principles, you can make more informed decisions and thus make more of your money in the long run.

Diversification

Diversification means spreading capital across different investments instead of putting all your eggs in one basket. This can mean, for example, not only buying shares in a company, but investing in many different companies, asset classes (e.g. stocks, bonds or real estate) or industries (e.g. healthcare, finance, industry or information technology). This reduces the risk that a single loss will be particularly significant. Fittingly, there is the well-known folk wisdom: "Don't put all your eggs in one basket." 

The more diverse your stock portfolio, the lower your unsystematic risk. This is the risk that affects individual companies only, for example if a company reports poor results or a product fails. This is because, while the price of one stock may fall, the price of another may rise at the same time. This usually balances out the overall effect. This principle is called diversification. However, risk can never be eliminated entirely because there are still influences that affect all companies, such as economic crises or changes in interest rates. This residual risk is called systematic risk. It remains even if you have invested very broadly.

A broad diversification is particularly easy and efficient with so-called ETFs (exchange-traded funds). These are traded on the stock exchange and bundle many different securities – for example, shares from different industries, countries or even entire markets – in a single fund.

Risk and Return

When you invest money, the following basically happens:

You use your capital to grow it. In doing so, you hope for a return, i.e. a profit or income in the form of interest, dividends or a higher sales price of an investment.

On the other hand, there is the risk, i.e. the uncertainty as to whether your investment will develop as hoped. The value can fluctuate and, in the worst case, you may lose some or even all of the capital invested.

Why are risk and return related?

  • High return potential = usually higher risk
    Example: Shares of small, fast-growing companies can rise sharply in value, but can also fall quickly and significantly.
  • Low risk = usually lower return opportunity
    Example: A call money account is safe, but currently only yields low interest rates.

You can think of it like a scale. On the one hand there is security, on the other hand the chance of higher profits. The more security is desired, the more potential returns usually have to be given up – and vice versa.

Risk Tolerance vs. Risk Capacity

The willingness to take risks when investing depends not only on personal attitude, but also on financial possibilities. In this context,  a distinction is made  between risk tolerance and risk capacity:

  • Risk tolerance describes the psychological willingness to endure fluctuations or losses. It varies from person to person and is emotionally influenced: Some people sleep soundly even though their investments fluctuate greatly, while others feel uncomfortable even with small losses. Risk tolerance often depends on experience, security needs and personal goals.

  • Risk capacity, on the other hand, refers to the objective financial opportunity to take risks. It results from factors such as income, assets, obligations and the time horizon of the investment. For example, those who have sufficient reserves and do not need the money invested in the short term have a higher risk capacity.

Ideally, risk tolerance and risk capacity match. In practice, however, it often happens that someone would be financially able to bear risks, but emotionally struggles to do so – or vice versa. An upcoming home purchase can affect both aspects. The risk capacity decreases because the money will soon be needed. At the same time, risk tolerance often decreases as emotional security becomes more important. Thus, risk tolerance and risk capacity can change over time. Accordingly, the investment portfolio should be reviewed regularly and the equity allocation should be increased or reduced, for example. 

Investment Horizon

The investment horizon indicates how long the capital should or can remain invested before it is needed again. The longer the investment horizon, the better it is to sit out short-term fluctuations in the markets and take advantage of the opportunities offered by the capital market. Long-term thinking usually offers higher earnings prospects and makes it easier to offset risks.

However, the investment horizon can change due to personal life events, for example when buying a house. In such cases, the risk capacity, i.e. the individual ability to accept fluctuations in the value or losses of an investment, often decreases. If you know that you will need money to buy real estate in a few years, you should tend to invest more cautiously and pay more attention to value retention and liquidity. In this way, he ensures that the money is available at the desired time.

Compound Interest

With compound interest, interest already earned is not paid out, but reinvested. In the next period, interest will accrue not only on the original amount, but also on the interest previously earned. Over time, compound interest can thus ensure that assets grow faster and faster. For example, CHF 1,000 becomes around CHF 4,321.95 after 30 years at 5% interest per year, without any additional money being paid in. However, this presupposes that the markets develop positively on average and that the interest earned is continuously reinvested.

  • Red dashed line: Simple interest rate – interest only on the initial capital
  • Blue solid line: Compound interest effect – interest on capital including interest already earned