Every investor has the tools at their disposal to make a fortune in the stock market. The problem is, while the tools are there, most investors make severe mistakes throughout their investing career, which cost them dearly.
And there’s one crucial mistake that’s more damaging than all of the others put together.
Rule one: Don’t lose money
The most prominent mistake investors tend to make is losing money. At first, this might seem like an obvious statement to make. No one wants to lose money, and if there was a way to invest that is 100% risk-free, I’m sure every investor would jump at the chance.
However, there’s a bit more to this statement than first meets the eye.
You see, a large percentage of investors believe that volatility defines risk. The more volatile the stock, the more risk it has. But that isn’t the right way of thinking about the market. Instead, the world’s best investors define risk as the chance of losing 100% of your invested capital.
The trick is to focus on how much you could lose from any investment, not how much you could gain. For example, that AIM mining stock might be worth 20 times its value IF it strikes gold. But what are the chances of everything going to plan?
According to one set of analysts, the percentage of small mining companies that can successfully find, explore, develop a mine and start producing, is around 2%. So, in this scenario, you have a 98% chance of losing money and a 2% chance of making money.
This is an imperfect example, but I think it’s a great way of showing how vital it is to consider how much you stand to lose with investment opportunity before taking the plunge.
Twice as hard
Another thing to consider with losses is that it’s twice as hard to make money back you’ve lost. If that AIM mining stock falls 60%, and you lose 60% of your capital, it will take a return of 150% to make your money back.
If the investment is a complete disaster and you lose 98% of your hard earned money, to get back to the starting point, you’ll have to find an investment that produces a return of 4,900%! That’s virtually impossible.
So, how can you avoid breaking investing’s rule number one? The best way is to stick to established businesses and FTSE 100 constituents are a great example. Royal Dutch Shell, for example, has been producing returns for investors for more than seven decades. British American Tobacco has a similar record. The company’s share price might have declined over the past few months, but the risks of investors losing everything are slim.
Another alternative is to use a simple index tracker fund. A FTSE 250 fund gives you instant exposure to the UK’s top 250 listed companies. This diversification means that the chances of investors suffering a 100% loss is virtually zero.
Put simply, it’s possible to avoid investment losses if you avoid the riskiest companies, and stick with the market’s long-term winners.
Rupert Hargreaves owns shares in Royal Dutch Shell and British American Tobacco. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.