Imagine an investor is fortunate to have £1,000 saved up and ready to put to work in UK shares. What would be the best way to invest this money in the stock market?
This is a relatively simple question. Yet the answer isn’t so straightforward. Why? Because an investment journey is a highly personal endeavour.
There are a lot of factors at play which determine what is and isn’t a good investment. And most are linked to personal circumstances. In other words, the best stock to buy for one investor might be the worst for another.
With that in mind, let’s explore some key aspects of the decision-making process when it comes to picking stocks and building a portfolio in general.
Laying a solid foundation
Like any investment, UK shares carry both risk and reward. Typically, taking on more exposure to volatility and operating risks leads to greater potential returns. However, the objective of any portfolio is to maximise the gains while not exceeding a certain risk level.
This level is more commonly known as risk tolerance. And it’s different for every investor. To some, losing up to 50% of a single position is frustrating but ultimately not a catastrophe. For others, that’s a one-way ticket to having some horrible, restless nights.
Establishing a risk profile is a critical first step that most new investors often miss. And generally speaking, it’s better to set the limit slightly lower than what investors actually think their limit is. Why? Because numerous studies have shown that individuals tend to overestimate their ability to stomach losses.
Picking the right investment
Once an investor knows how much volatility they’re comfortable dealing with, it becomes a lot easier to narrow down the pool of potential investments to choose from.
For example, young biotech businesses are arguably some of the most volatile enterprises on the stock market. A few have gone on to deliver gargantuan returns following a successful drug launch. But most have gone to zero, leaving investors with nothing. Therefore, such companies are most likely unsuitable for risk-averse individuals.
The opposite is also true. A boring industrial manufacturer likely won’t offer much in terms of growth. However, an established enterprise with a long client list and robust demand could bring significant stability and probably some dividends as well.
For a risk-seeking investor, this type of stock may not be a wise investment. Why? Because there are likely other opportunities to achieve superior returns, albeit at a higher level of risk. The difference between the performance of the two companies is called the opportunity cost, and generally speaking, it’s something worth minimising where possible.
The bottom line
Whether investing in disruptive start-ups with industry stalwarts, it’s paramount to investigate each company carefully. Every business has its flaws. And even the most popular British stocks can often end up being a bad investment.
It may also be sensible to split the grand across two or three different promising businesses. This not only adds a bit of diversity but also reduces a portfolio’s overall risk level.
