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How to invest on AIM without losing your shirt

Photo credit: Rafael Matsunaga. Licence: http://creativecommons.org/licenses/by/2.0/

The AIM market is probably the most controversial place to invest in the UK. The index’s constituents have a reputation for fraud, corruption and general lack of respect for investors, none of which are appealing investment characteristics.

AIM’s big problem 

The big problem with the AIM market is the light-touch approach employed by regulators. At its core, the market is designed to help early stage companies connect with investors and raise capital easily. 

It’s not just the businesses that benefit from this approach. Investors also benefit from having a liquid market to buy and sell their shares in early-stage companies, unlike other methods such as venture capital and private equity. 

Unfortunately, AIM was never going to be a market without faults as it would be almost impossible to accomplish the above goals while at the same time enforcing a strict set of regulations. Most small companies just don’t have the resources to ensure that they’re meeting a long list of rules and regulations. If a list were to be introduced, it’s likely many companies would drop off AIM altogether, and the market would have failed to meet its key objectives.

Some diamonds in the rough 

Still, even though AIM has a bad reputation, some companies on the market could be great investments. But investors have to approach these companies with much more caution than usual. Investing in early-stage growth companies is a risky business, and you need to be able to know and understand the benefits and pitfalls before you get involved.

I believe that you can be a successful AIM investor by following several simple rules, rules that I applied to all of my investment decisions. First off, you need to be able to trust the company’s management. For AIM businesses in particular, the decisions made by management can be extremely telling. Unlike blue chips, AIM management teams are usually small with a large amount of influence over the rest of the company. If the management owns a significant percentage of the company, takes a relatively modest salary and has no history of lying to or misleading shareholders, then you’re on the right track.

Secondly, I like to follow the cash. Companies that have a substantial net cash balance, positive free cash flow and return cash to shareholders via dividends or buybacks are likely to produce steady returns over the long term.

Thirdly, on AIM you need to diversify. Diversification is an important part of investing anyway, but with AIM stocks it’s of particular importance. The thing about early-stage high-growth companies is that they can return zero or 100 times your initial investment so if you only devote 1% of your portfolio to a particular company, the returns can still be life changing. 

This also means  it may be wise to devote only a small portion of your portfolio to AIM stocks. If you invest 90% in blue chips and 10% in AIM shares, even if all the AIM stocks go to zero you won’t lose your shirt and there’s still the potential for massive gains.

Make money, not mistakes

A recent study conducted by financial research firm DALBAR found that the average investor realised an annual return of only 3.7% a year over the past three decades, underperforming the wider market by around 5.3% annually thanks to poor investment decisions. 

To help you streamline your investment process, realise and understand the most common investor mis-steps, the Motley Fool has put together this new free report entitled The Worst Mistakes Investors Make.

The report is a collection of Foolish wisdom, which should help you avoid needlessly losing too many more profits. Click here to download your copy today.

Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.