The German financial markets regulator BaFin has issued guidelines on personal investing. This article will give you the main points.
„Investing is simple but not easy,” said Warren Buffett, who made billions by following straightforward investment strategies. Buffett once revealed he only invests in assets that he fully understands — a principle that has made Buffett one of the most successful investors in the world. What worked for Buffett also works for retail investors, independently of income, level of wealth, or financial education.
To provide guidance on simple investment strategies, the German Federal Financial Supervisory Authority BaFin published a brochure for retail investors last month. Whether you either intend to save up for retirement or if you want to buy a property, these guidelines are for you.
1. Get an overview of your financial situation
You cannot know where you are going unless you first know where you stand. Before you start thinking about investments, ask yourself these questions:
How much cash do you have available?
- Which assets do you already own (securities, real estate, etc.)?
- Do you have any debt, if yes, how much, and what interest rate do you pay?
- What does your monthly net cash flow look like — meaning your monthly income minus your expenses?
Based on this analysis, you will gain an understanding of your current wealth situation and you will know the amount of money you have available every month to undertake investments.
2. Build up a safety buffer
Nobody knows what’s going to happen tomorrow. Your car might break down and you will need money to fix it; you could lose your job or get sick. Even though nobody wants to think about such situations, we do need to plan for the worst-case scenario. The BaFin, therefore, recommends building a cash reserve equivalent to three times your monthly income.
3. Pay off debt fast
Be cautious with leveraging. If you plan to invest money that you have borrowed beforehand, it makes economic sense to pay off debt before you start investing. Interest rates on consumer loans often exceed the potential returns you could achieve leveraging the borrowed money.
Loan agreements typically include a clause allowing borrowers to repay debt sooner. However, most banks will charge a penalty on premature loan repayments. In Germany, banks can charge a maximum of 1 percent of the remaining loan — that is, in case of a consumer loan; business loans are subject to different rules. Talk to your bank and discuss the repayment modalities.
4. Define your investment goals
There is no free lunch! Higher returns are likely to come at a higher risk. Therefore, investors need to consider the trade-off between risk, return, and liquidity. Ask yourself those three questions:
- How much risk are you willing to take?
- What returns do you expect?
- Are you willing to lock up your cash for a longer time?
Personal investment goals differ widely depending on individual circumstances and preferences. A family with children may be more concerned about the safety of their investments, while a single person in his/her mid-20s may be willing to accept more risk for higher returns. Write down what you want to achieve and define your personal risk-return profile.
5. Portfolio diversification: Don’t put all eggs in one basket
Portfolio diversification means to invest in different assets and asset classes to minimize your risk exposure while maximizing potential returns. If one of your investments goes wrong, you will still have other assets to at least partly compensate for your losses.
A conservatively diversified portfolio usually consists of stocks, bonds, cash, and alternative assets such as real estate or precious metals. The exact portfolio mix depends on your risk appetite and returns expectations. Stocks and alternative assets are typically riskier than bonds and cash, but they yield higher expected returns.
6. Pick your investments based on your individual investor profile
At this point, you know how much money you can invest and what your investment preferences look like. As a next step, you have to identify assets that fit your budget and risk-return profile. Investors with greater risk appetite invest more heavily in stocks and alternative assets, whereas more risk-averse investors will lean toward bonds and cash.
Keep in mind what Warren Buffett says: Only invest in assets that you understand! Capital markets offer all kinds of investment vehicles, from structures as simple as government bonds to complex instruments like derivatives. For most retail investors, simplicity is the way to go.
7. Keep your costs in check
Portfolio managers, financial advisers, insurance companies, or real estate funds will charge management fees. And even if you decide to manage your portfolio by yourself, you will still have to pay brokerage and transaction fees.
Get an idea of what these fees look like before you start investing and include them in your calculations. Fees will lower your return, and they can vary greatly depending on the service provider. Compare different options so you can identify the best choice. Keep in mind, however, that a percentage is given in the internal rate of return (IRR) already reflects these costs.
8. Only work with genuine businesses
Buyer beware. Not everyone has your best interests at heart. In Germany, businesses that offer financial services or issue securities need prior approval by the BaFin. You can find a list of all companies that are regulated by the BaFin here: http://www.bafin.de/unternehmen
Keep in mind that the BaFin only ensures that companies or securities are compliant with existing laws and regulations. Just because a company or security is regulated by the BaFin, doesn’t mean it’s a good investment. However, the BaFin’s supervision does at least provide a first quality check.
Also keep in mind that every security issuer generally needs to publish a securities prospectus. It must be found on the website. If you do not find it there, check out the official BaFin database.
9. Keep an eye on your portfolio
If you invest in the long term, you won’t have to look at your portfolio every day. Price volatility is not that much of a concern for long term investors. Mostly, it’s better if you don’t even react to temporary market downturns but instead wait for prices to recover.
Nevertheless, you still need to review your portfolio regularly. Your investment preferences will change over time and you may want to re-allocate some of your assets. Also, the cost of investment could change, for example, because service providers increase their fees.
The above strategy provides basic guidelines. Some investors may have more complex requirements, but for most retail investors, the steps outlined by the BaFin cover the most critical aspects of investing. To review the original BaFin brochure — only available in German language — click here.