Six basic rules of share investing

What you’ll learn:

• Why it’s important to do plenty of research before you buy.
• Why investing in individual shares is a risky approach.
• Why diversification matters.

Investing in shares is far from an exact science, but there are certain rules which can help investors decide not only where to invest, but also how to manage some of the risks involved.

Remember, however, that whatever steps you take reduce risk, shares can be volatile and their values can fall as quickly as they rise, so you could get back less than you put in.

Do plenty of research before buying

Always do your homework before you invest. One way of deciding whether a company is worth investing in is to look at what its price-to-earnings (PE) ratio is.

This can be found by dividing a share’s value by the earnings per share over the past year. The higher the PE ratio is, then in theory the better the investment looks. Bear in mind, however, that if a share has a low PE ratio, it could simply be undervalued by the market rather than a bad investment. To help you work out how a company is doing relative to its peers, it’s worth taking a look at the PEs of businesses in the same sector.

You should also look at the latest results of any company you are considering investing in to see what their profit margin is like, but bear in mind that past performance should not be seen as a guide to the future. If a company has a large ratio of debt to equity this could be cause for concern because it means more of a company’s earnings are going to have to go towards paying off this debt.

Find out more about how to spot a long-term winner 

Don’t invest in anything you don’t understand

Steer clear of any investments you don’t fully understand. It’s best to stick with areas and companies you are familiar with, rather than taking a punt on something you don’t know much about.

Many first-time investors like to stay close to home and invest in UK firms. Companies listed on the UK’s main index, the FTSE 100, are usually viewed as good starting point.

Even if you see certain companies tipped to be top performers, you should always be sceptical, particularly if you don’t know what they actually do, or what their prospects are.

Understand the differences between small and large companies

There are advantages and disadvantages to investing in both small and large companies, so it’s important to weigh these up before you invest.

For example, investing in large blue-chip companies is often considered a route to steadier, stable returns. However, because of their already considerable size, these companies tend not to have significant growth rates, so their shares are unlikely to appreciate rapidly. Conversely, they have tended to suffer less than smaller companies’ stocks in bad times.

That is not to say that during periods of market volatility, blue-chip share prices won’t fall. Like all investments, their value can go down as well as up and you could get back less than you put in.

Smaller companies, which include those listed on the Alternative Investment Market (AIM), may have the potential to grow profits more quickly, and this can be reflected in rapid share price rises. However, they are also more susceptible to shocks and can also lose money quickly, which in turn can send their shares falling.

Smaller company shares are also more illiquid too, with fewer people willing to buy them, particularly when times are tough. This means that they can be harder to sell when you want and at the price you want.

Be patient

Successful investing is often about ‘time in the market’, and not ‘timing the market’.

It’s impossible to accurately forecast the best time to either buy or sell an investment, but all investments need time to grow, so the longer your money is in the market, the more chance you have of reaching your goals. You should therefore only invest money you won’t need to touch for at least five years, but preferably longer.

Find out more about the significance of spending time in the market

Keep emotions out of your investment decisions

It’s human nature to feel a sense of fear and panic when you see the investments you have put money into fall in value, and a sense of excitement when they are increasing in value.

However, our emotions can often prompt us to make knee-jerk reactions that could mean turning paper losses into realised ones. Think carefully about how you would react if your investments did plummet in value, and if you are tempted to sell during periods of stock market volatility, focus on the reasons why you picked your investments in the first place.

Try not to spend too much time scrutinising your investments either. It is important to keep track of how they are performing, even if you are investing for the long term. Keeping your finger on the pulse and reviewing your portfolio frequently throughout the year is often sufficient.

Find out more about the impact of your emotions on your investments

Spread your risk

Buying individual shares in a company is risky, as you’re relying solely on the performance of that particular company. It’s therefore a good idea to spread your risk by investing in a range of different companies across different sectors.

Remember that pooled investments such as unit trusts or Open Ended Investment Companies (OEICs), or investment trusts can provide a good way for smaller investors to gain easy access to a wide range of stocks and shares. A fund manager is responsible for choosing which shares to hold, and will usually focus on a particular sector or geographical area. As your money is invested in many different shares, the risks are lower than if you invest in just a few.

You can either select funds or shares yourself, or you could go for a ‘one stop shop’ approach. Barclays Smart Investor, for example, has just launched Ready-made Investments, which remove the complexity from investing by offering a choice of funds matched to your chosen risk profile and financial goals. Smart Investor doesn’t offer personal advice. If you’re unsure where to invest, seek professional financial advice.