The world of investing can seem complicated and intimidating to most beginning investors, but it doesn't have to. As long as you know some basic principles of what to do and what to avoid, you'll be on the right track and can prevent yourself from making costly mistakes.
Here are three rules all beginning investors should know and use in their portfolios.
Don't borrow money to invest
In the investing world, the act of borrowing money to invest is called "margin," and it should generally be avoided. While investing on margin is a useful tool for many professional traders, it doesn't belong in a solid long-term strategy. There are two reasons for this.
First, it can be expensive. You have to pay interest on the money you borrow, which can add up to 7% or more on an annual basis. So, if you borrow money to buy stock, you'll need to achieve total returns greater than your margin interest rate just to break even.
The second reason is that when things go badly, using margin can be catastrophic. Let's say that you deposit $5,000 into your account, and use margin to buy $10,000 worth of some stock you have your eye on. If the share price takes a nosedive (think bank stocks in 2008) and drop by 50%, your entire investment would be wiped out, since that would translate to a loss of $5,000, the same as you deposited.
So, stick to investing the money you have. Doing so will limit your downside, and helps to stack the investing odds in your favor.
Keep it simple
If you can't explain what a company does and how it makes its money in a sentence or two, you probably shouldn't invest in it. Maybe it's a good company, maybe it's not -- the point is, you have no idea.
Instead, you should invest in things that make sense to you. Companies with an easy-to-understand business and profit strategy tend to do well over time. For example, Coca Cola is one of the easiest businesses to understand. The company's goal is to leverage its branding power all over the world and to gradually add more products to its portfolio. Warren Buffett once famously said that "a ham sandwich could run Coca Cola," meaning it's basically a company that runs itself. That's the kind of investment you want.
The same principle holds true no matter how long you've been investing. For example, I don't understand the dynamics of the biotech industry very well, so I won't invest in any speculative biotech stocks. However, I understand the banking business very well, which is why my portfolio has a bunch of bank stocks in it.
Looking for "home runs" can make you go broke, but a lot of base hits can make you rich
Buying stocks you think could produce amazing gains in a short period of time is rarely a good idea, especially before you really know what you're doing. Sure, some "speculative" stocks end up as home runs and rise very quickly, as Tesla and Netflix have in recent years. However, these types of stocks can lose tons of money just as quickly and are best reserved for investors who know how to properly incorporate high-risk investments into their portfolio.
For example, an investment in Fannie Mae could make a ton of money, if certain things go your way. In fact, if the courts rule that the shareholders are entitled to some of the company's profits, a $2 stock could become a $20 stock rather quickly. On the other hand, if the courts rule against shareholders, and/or Congress is successful in dismantling Fannie Mae, the share price could drop to zero.
On the other hand, investing in stocks that consistently produce good returns, and consistently grow their profits and dividends, is the most certain path to long-term wealth there is. Rock-solid dividend growth stocks like Johnson & Johnson, Procter & Gamble, and Colgate Palmolive tend to outperform the market over the long run, with lower risk than many other stocks.
In investing, slow and steady will win the race. Just consider that Warren Buffett made more than 99% of his money after he turned 50, and he made it a little at a time.
To sum it up
In short, if you're new to investing, don't take on any high-risk stocks, and instead invest in easy-to-understand companies that produce consistent results. Additionally, only buy these stocks with money that you already have in your account.
There is definitely a learning curve to investing, but as long as you get started the right way, you'll set yourself up to learn as you go along, without leaving yourself vulnerable to "rookie mistakes" taking a bite out of your portfolio.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Johnson & Johnson, Netflix, Procter & Gamble, and Tesla Motors. The Motley Fool owns shares of Johnson & Johnson, Netflix, and Tesla Motors and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.