Basic Concepts of Investing
You have done your research and due diligence, you like the company, the products and you really feel after all you have learned that the set of stocks before you is where you want to stick your investment money. By all means, at this point, invest the money. After all you have learned, it isn’t going to get any better than this for the buy in. Now let’s go over some of the basics of investing in the stock market. While this may seem a bit odd to talk about after you have already pressed the buy button, in all honesty, this is when investing starts, not where it ends.
Our main objective is to make money. That is our guideline and our goal. The first principle to making money with stocks is to sell the losers and let the winner’s ride. It is fairly common to hear strategies of selling once the investment has doubled or tripled, and many people have a problem with letting go of a declining stock.
The principle is easy to agree with, but the reality is that we tend to get sucked in to an investment hoping it will rebound. If you are hoping, you shouldn’t be investing. There needs to be solid reasons for our play, not just a feeling. Again, this sounds like fairly plain and simple advice, but more often than not I hear “I should have…” from intelligent, well researched investors riding a hope to the bottom.
Riding out the winner can be just as difficult to do at times. The stock doubles and we start thinking “sell”. After all, we have doubled our money, we didn’t get burned. We’ll get the money out, and start the research again.
Peter Lynch often talked about his “ten-baggers” which were a small set of stocks which had increased in value by 10 fold. It is said that most of his overall success was due to keeping well informed regarding a small number of stocks, which returned big. The truth is that doubling on small buy-in stocks isn’t that hard to accomplish; however, the time and effort involved in picking good stocks is a huge investment. If you have a personal policy to sell after a stock has increased by a certain multiple – say three, for instance – you may never fully ride out a winner. Don’t underestimate a stock that is performing well by sticking to rigid personal rules – if you don’t have a good understanding of the potential of your investments, your personal rules may end up being arbitrary and limiting.
Selling the loser after all of that research and time, can be very difficult, but like it or not, there is no guarantee that a stock will come back up after a protracted decline. Somewhere along the line we forget that we can do all the right moves and still not make the right choice. If a stock is in a protracted decline then cut it loose.
Never be ego-ed into keeping a stock you know is a looser, just because you like the company.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses.
Hot Tips are just as devastating. You can consider this the hottest tip you are ever going to get, “don’t buy into hot tips”. Whether the tip comes from your brother, cousin, neighbor, or even your broker, no one can guarantee what a stock will do. When you make an investment, it’s important you know the reasons for doing so: do your own research and analysis of any company before investing. Tidbits are for bedtime snacks and toppings on frozen yogurt, not for information. We really want the full meal for information we are going to place our money on.
Just about anyone can get a feeling or hear something the right way. Some people believe that it is better to be lucky than good. Statistics and my personal adventures down both paths tell me otherwise. Be informed in your investments, not just vested. My personal rule is, if my broker has to have an answer today, then the answer is no. Absolutely no investment is worth my money if it is not a long term investment. I’m not against doubling my money in a week, that’s why I play poker, but I don’t take that mindset into my investments.
Rule 62, don’t sweat the small stuff. There are several great guides out there with formulas and trend advice. They are great reads and good guides, but when you get to the end of the day, add one more rule to the list ‘don’t sweat the small stuff’. The market reacts like, well, like millions of investors all over the world are trying to figure out what is going to happen next. Rumor mills grind, and special news reports investigate and political bodies rub against other political bodies. As a long term investor learn to watch short term movements with a casual eye. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitable volatility of the short term.
Granted, active traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement – the one that occurs over many years – so keep your focus on developing your overall investment philosophy by educating yourself.
Investors often place too much importance on the P/E ratio. Because it is one key tool among many, using only this ratio to make buy or sell decisions is dangerous and ill-advised.
The P/E ratio (for those that don’t know) is one of the tools often used by investors to asses the value of a potential stock investment. The P/E shows the relationship between a stock price and its company’s earnings (or profits) per share of stock. Let’s say that the XYZ Company has a stock trading value today of $20 per share. Last year the XYZ Company earned $1 per share. So the P/E is 20 / 1 or 20.
“Great!” you say, “and what does that mean?” For starters, notice that the ratio expresses stock prices in terms of the earnings per share (EPS). The P/E ratio uses the earnings of a company to value that company’s stock. Earnings are indeed the inside track to valuing a company’s stock, and the P/E is a nice simple tool that quickly values a company off of earnings. Unfortunately, like any useful tool, such as the flat head screw driver or hammer, people have a tendency to grab it for use even for jobs where another tool would give better performance. The P/E formula most folks know from the financial sections of news papers and some Internet web services is actually a simplified version of the dividend discount model, which matters only in that the P/E ratio is a shortcut valuation technique that omits more than it includes. Specifically the P/E ignores risk and the time value of money. It also wrongly assumes a one-year snapshot of earnings is representative of the company’s sustainable earnings power. As a result, eyeballing a company’s P/E ratio to determine its value is a little like trying to figure out how much a car is worth by sampling the exhaust.
The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesn’t necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued. We will discuss P/E and EPS more in-depth later, let us continue on with the basic concepts of investing first.
Another misconception is Penny-stocks. Some believe it is better to stick with lower priced stocks, rather than go for the higher priced stocks. Basically however the starting of this logic is wrong. Whether you purchase 100 $5 shares or 100 $75 shares, if you lose all of your money on them, then you still have a 100% loss ratio. A bad stock is a bad stock. Don’t let the price of a stock throw you, start with the question, “Is it a good stock?”
You are going to learn new tools and strategies all the time. I don’t believe I have seen a year go by that there was not some new book on stock picking strategies on the shelves. We just talked a little about P/E and EPS, but there are other common strategies. For example you could value a real-estate company’s stock not off its earnings but by using the value of its land. Dividends could be used to value a company that pays a large dividend more off of the value of its dividend than its earnings. Every year someone comes up with something new and there are volumes out there already full of strategies.
After reviewing enough of them to get an idea of the basics, find a strategy which works for you and stick with it. There are many ways to the top of the mountain, but all of the paths end in the same place. An investor who jumps from path to path often only reaps the worst parts of the strategies he jumps between.
I’m not saying that you should stop learning new strategies, or not to adapt your current strategy to a new technique if it makes sense to do so. What I’m suggesting here is to develop your strategy with care and then hone the technique over time. Second guessing yourself is the killer of portfolios.
The real tough part is that we are trying to make informed investment decisions on events and facts that have not happened yet. No matter what, at our best position we are still faced with glaring black holes in our information base. Yes, we have historical data and current data, but what really matters is the future, isn’t it?
A quote from Peter Lynch’s book “One Up on Wall Street” about his experience with Subaru demonstrates this: “If I’d bothered to ask myself, ‘How can this stock go any higher?’ I would have never bought Subaru after it already went up twenty-fold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that.” Keep the idea fresh in your mind that the future, really doesn’t depend on the past for its shape. Use your strategies by focusing on the future potential.
We just talked about Penny stocks, but I do want to point out that small-caps are not bad investments. Many great companies are household names, but there are several non-profitable investments floating around the household as well. From 1926-2001, small-cap stocks in the U.S. returned an average of 12.27% while the S&P 500 returned 10.53%. Many investors were thrown off the startup and small company investment during the Dot.Com era, but really what happened then was not that we were investing in small start ups, but that we forgot the basics of investing. A great many of the Dot.Com businesses had no earnings, and yet they were invested into anyway.
I guess what I’m reiterating here is that finding good stocks is not based on the size of the company, small cap or blue chip. General Motors is a great example, a blue chip stock currently going south in a big way.
It all ends with taxes, but that is not where it begins. Placing taxes or tax concerns into your investment strategies, is not a very good idea. Such a tactic can cause some very poor, misguided decisions. Tax implications are important, but that is not our goal, “to pay taxes”, our goal is to “make money”. Definitely find the ways to pay fewer taxes, less often. You should always attempt to minimize the amount of tax you pay and maximize your after-tax return, but the situations are rare where you’ll want to put tax considerations above all else when making an investment decision. Make the money first, and then worry about the tax man.