Five golden principles of investing
A conversation with our Head of Investor Education, Cameron Watson, who reveals the fundamental principles for building a robust portfolio to achieve long-term wealth with confidence.
Where should I start?
1. Set goals
Set clear goals. Investing with a purpose and having clear objectives keeps you on track during market ups and downs. Goals can include buying a house, saving for education, or planning for retirement. Having clear goals, as well as understanding factors like your tolerance for risk and investment time horizon helps clarify what mix of investments is most suitable for you.
Fees and tax are also important considerations, but they should not drive investment decisions.
What’s the first thing investors should know when building a portfolio?
2. The importance of diversification
Diversification is key. It’s about spreading your investments across the four main asset classes - cash, bonds, property, and shares. But it doesn’t stop there - within each asset class you should also diversify.
A shortcut to achieve diversification is to invest in funds. A fund is made up of company shares, bonds, cash and can also specialise in a specific sector or market such as property or the US market. This allows you to gain exposure to many companies, asset types and markets through a single investment.
Diversification is often talked about as a way of reducing risk, which is true - when it comes to investing, there is safety in numbers. It is difficult to predict which markets or shares will do best and it is prudent to spread your investments across industries and countries to increase the chance of benefiting from gains.
For Kiwis, living in this beautiful but small country, we have to recognise it comes with its own unique geological, meteorological and economic risks. As such, a diversified portfolio should include an allocation to overseas investments.
What about timing the market?
3. Time, not timing
Forget timing. Focus on time. Markets are in perpetual motion and move both up and down. Trying to predict the best time to buy or sell can be both stressful and counterproductive.
Investing in a lump sum means you invest at a point in time, exposing you to what is called ‘market-timing risk’ – the risk that the market falls not long after you invest.
That’s why we recommend regular investing over time - something called dollar cost averaging. This strategy lets you invest at different market levels, often buying more when prices are lower, which can reduce your average purchase price and lead to better long-term results.
Plus, investing regularly takes the emotion out of the process, which can lead to better decisions and less stress.
Can you tell us more about the power of dollar cost averaging?
Our example is hypothetical only. For clarity, it does not use actual prices and ignores brokerage.
Our example shows how a regular investor using dollar cost averaging may benefit from price declines, which mean they can invest at a lower entry price and therefore buy more shares, thus enhancing their long-term return.
The benefit of starting early is that you will be investing for a longer time, and time is the fuel for arguably the most powerful force in investing, compounding.
How does compounding work?
Compounding is a simple but powerful concept. It’s the process of earning returns on your returns. For example, if you invest $1,000 and earn a return of 5%, your portfolio will grow by $50 to $1,050.
Over the second year, if your portfolio again gains 5% your return will be $52.50. The return is $2.50 higher because you earn the return not only on your original $1,000 but also on the $50 you earned last year (5% on $50 is $2.50).
The power of compounding becomes more obvious over the long term. After 10 years the original investment would be worth $1,629, and after 20 years $2,653.
Regular savers can benefit from compounding. Someone who can save $200 a month ($2,400 a year) for 20 years will have invested $48,000. Using an illustrative annual return of 5% (after tax and fees), their end value would be $81,161, meaning 41% of the end value will have come from compounded returns.
If this person invests for 30 years instead of 20, they will invest $72,000 and their end value would be $163,075, which means over half (56%) of their end value would have come from compounded returns.
Do the same exercise for 40 years and they will invest $96,000 and their end value will be $296,505, meaning two-thirds (68%) of their end value would have come from compounded returns.
Fees can have an impact on compounding over time, so it’s important to consider returns after total costs.
Albert Einstein even called compounding the "eighth wonder of the world," and he wasn’t wrong—over decades, it can make a significant difference in your portfolio’s growth.
An illustration of how compounding works
How do you know if your portfolio is the right mix?
4. Sleep test
It’s all about the “sleep test,” the fourth golden principle of investing. If your portfolio keeps you up at night, it’s a sign that something is not quite right. A good mix of lower-risk and higher-risk assets should align with your tolerance for risk. While it has a feel-good factor – who needs extra stress in their lives - there is also a serious angle to this maxim.
This balance can help you ride out market downturns and avoid the urge to sell during a market decline, which is crucial for long-term success. Selling after a market fall can lock in losses and prevent you from benefiting from any eventual recovery.
Being diversified is not just about mitigating risk. It also reduces worries about your long-term financial security. By having a balanced portfolio which includes growth assets, like shares, you can feel more confident that your savings grow enough to meet your long-term future needs.
How can investors combine a long-term, balanced portfolio with more active, higher-risk investments?
5. Take a ‘core and niche’ approach
Our fifth golden principle talks about having a core and niche approach.
It is important to maintain a well-diversified balanced portfolio. At the same time, many of us may like to make more active, higher-risk investments. Your ‘core’ portfolio is your key long-term investments. It should be well-diversified and designed to meet your long-term goals.
Our Core Series of ETFs (Exchange Traded Funds) serve as building blocks, providing an easy starting point for establishing strong investment foundations.
On the other hand, your niche investments are smaller and allows you to make more active positions —like investing in sector-specific funds or higher-risk assets.
By seeing them as separate investments, even if your niche investment doesn’t perform well, it won’t undermine the core of your portfolio or your long-term financial plans.
A ‘core and niche’ approach is a great way of giving us scope to make some active investments, without risking our core portfolio and long-term investing goals.
Conclusion
In summary, building a robust portfolio requires a focus on five golden principles: diversification, setting clear goals, prioritizing time over timing, passing the sleep test, and balancing risk through a core and niche approach. By applying these principles, you can build a portfolio that aligns with your goals, suits your risk tolerance, and stands the test of time, helping you achieve financial success with confidence.
Adopt the five golden principles of investing now.
This information is issued by Smartshares Limited (Smart), a wholly owned subsidiary of NZX Limited. Smart is the issuer and manager of the Smart Exchange Traded Funds. The product disclosure statements are available at smartinvest.co.nz. Past performance is not a reliable guide to future performance. The calculations and returns used in this article are illustrative and intended as a guide only, and are not an indicator of future returns. The value of investments can go down as well as up and investors may not get back the full amount invested nor any particular rate of return referred to in this article. Returns are not guaranteed. This information is intended to provide a general guide and is based upon, and derived from sources Smart considers reliable. Neither Smart nor NZX Limited, or their respective directors and employees accept any liability for any errors, omissions, negligent misstatements, or for the results of any actions taken, or not taken in reliance on this information. This information is not a substitute for professional advice. In preparing this information Smart did not take into account the investment objectives, financial situation or particular needs of any particular person. Accordingly, before making any investment decision, Smart recommends professional assistance from a licensed Financial Advice Provider is sought.