Strtegies for Investing in Stocks
Courtesy : MassResources.org
Below are ten guidelines that are smart and often necessary to follow in order to be successful at long term investing in stocks.
1. "Buy low and sell high."
This is a very obvious bit of advice but achieving this goal can
be more difficult than it might seem and this simple rule can be easy to
forget. An obvious key to successfully investing in stocks is to pick
investments to buy that will increase in value over time and then
eventually sell the stock at a higher price. Some of the recommendations
and guidelines that follow may be helpful in following this first
principle.
It is important to understand that it is impossible to time the market
precisely. Even very skilled investors make mistakes, but they learn
from them and gradually make fewer bad investment decisions over time.
No investor buys and then sells at exactly the right price. But good
stock investors have the strategies, knowledge, and discipline to, much
more often than not, buy shares of stock at lower prices than what they
sell them at.
In order to "buy low" and "sell high" it is sometime necessary to do
the opposite of what the majority of investors seem to be doing. This is
called being a contrarian. When everyone else
is pessimistic about a company they have likely acted on their negative
opinions and sold shares of its stock. On the other hand, when
investors are very optimistic about the prospects of a company, they
have likely already acted on their hopefulness and purchased the stock.
An investor who can buy at an extreme moment when others have been
selling and sell when others have been aggressively buying may be able
to accomplish the goal of "buying low/selling high" more often than
those who follow the general consensus.
Unfortunately, this strategy doesn't always work! Sometimes there are
good reasons for investors' pessimism and a company is headed from bad
to worse. Someone who buys when everyone else is selling may end up
owning stock in a company with grim long term prospects. Alternatively,
selling shares of a great company with wonderful long term potential
(e.g., Microsoft in the early 1990s; Apple in the early 2000s) too soon can be very frustrating as well. Needless to say, successfully investing in stocks is never easy.
2. Understand what you are buying.
It is a good idea to have an understanding of the company you are
purchasing shares of its stock and be able to list solid reasons for why
you think the company’s earnings will increase over time. Many
investors rely on the advice of investment professionals and investment
services for recommendations on stocks to purchase (or sell). Seeking
out multiple sources of advice and opinion is a good idea in order to
more fully appreciate the pros and the cons of buying a particular
stock. Pay attention to who provides good versus bad advice so that,
over time, you can learn whose opinions to better trust. If you are
making your own investment decisions, it is not a good idea to put all
of your trust in any one individual or one investment services' advice.
Consider multiple opinions and do your own thinking as well.
Some investors meet with success by investing in companies for which
they already have a very good understanding (or hold a good opinion of)
because they like what the company makes or the service they provide.
This is a perfectly valid and, often, useful strategy. At the same time,
it is a good idea to do some research about the past financial
performance of a company and projections for its future earnings.
Personal experience can help, but there are many reasons why it will not
always lead to accurate predictions about the future stock price of a
company.
3. Patience is a virtue.
Sometimes an investor can be right about the stock he or she has
purchased but wrong on the timing as to when it was bought. A stock
might go down after it is purchased, but ultimately go way up in price
thereby creating a nice profit. In the long run, a company's stock price
will likely go up if the earnings of the company increases. In the
short term, it can be very hard to predict what causes the price of a
stock to go up or down. More often than not, patience is a virtue
when it comes to successful stock investing. If history is a guide, in
the long run the stock market goes up and many established companies
will do well as the broader national and world economies grow.
4. "Growth at a reasonable price" investing.
Two major strategies for choosing stocks to buy are "growth-oriented" and "value-oriented" approaches. Investors who favor growth stocks
look to buy companies which have earnings that are rapidly growing each
year (or expect to have significant earnings growth in future years
once they become more established). Investors who like to purchase value
stocks look for companies that are selling at a very cheap share price
in relation to the earnings per share (i.e., they have low P/E ratios).
Value investors are less focused on looking for companies with rapidly
growing earnings and more interested in buying what appear to be
"bargains." Both types of strategies can be effective. Growth investors
can meet with success by identifying companies early on that will
continue to grow their earnings for many years to come, with the share
price rising as well. Value investors can meet with success by
identifying companies that have experienced temporary setbacks
and purchase shares of stock at discounted prices (i.e., when they get
oversold by other investors who are overly pessimistic about a company's
situation).
The major risk that growth investors run into with their approach is
that they will pay a very rich price for a company with seemingly good
long term prospects. Even a small disappointment in the earnings of a
company with an expensive stock price (i.e., high P/E ratio) can result
in a big drop in the share price as investors reconsider how fast the
company will grow its earnings and sell the stock. A major setback in a
company with a high P/E ratio can devastate its share price (e.g., the
price of a stock could drop 25% or more on bad earnings news).
Alternatively, with a value-oriented investment approach, the risk in
owning what appears to be a cheap stock is that what seems like a
temporary setback is actually much more serious or permanent in nature. A
low share price, which looks like a bargain, may be well justified and
the price could head much lower as more investors sell the stock after
they come to recognize the long term nature of the company's problems.
Another investment strategy that attempts to blend the best of the
growth and value-oriented strategies is called "growth-at-a-reasonable
price" (GARP). Investors who follow this approach pay particular
attention to a stock's PEG ratio. This is the P/E of a stock divided by
its annual earnings growth rate. PEG ratios under 1.0 indicate that a
company's P/E ratio is less than its growth rate. The lower the PEG
ratio the more it suggests that the stock is reasonably valued (or even
undervalued). Alternatively, the greater the PEG ratio, the more
expensive the share price would seem to be.
A GARP investment strategy can offer protection against the
problematic risks of both growth and value-style approaches. Investors
who follow a GARP approach in a disciplined manner will draw a limit on
what they are willing to pay for a stock with fast growing earnings.
GARP investors like companies with fast growing earnings (the
denominator in the PEG ratio) but, at the same time, will insist that
this growth rate be high enough to justify a stock with a high P/E
ratio. Likewise, GARP investors will not purchase a stock simply because
it has a very low P/E ratio. If the company's earnings are not also
increasing at a decent rate, they will avoid buying the stock for fear
that the company's earnings have stopped growing (or worse have begun to
decline).
5. Some of the "secrets" to Warren Buffett's success as an investor.
Many people consider Warren Buffett to be the most successful stock
investor of all time. Beginning with a relatively small sum of money to
invest in the 1950s, Buffett's investment company, Berkshire Hathaway,
now has a market capitalization of over $250 billion and Buffett,
himself, is currently one of the wealthiest individuals in the world.
Buffett's success is due to a very disciplined and shrewd approach to
buying the right stocks and holding on to them for long periods of time,
only to sell them if the reasons for his initial investment have
changed significantly.
Buffett is a great illustration of an investor who has followed the
above listed guidelines virtually to perfection. He has a keen knack for
"buying low, then selling high." He is very patient in his approach,
both in terms of waiting until the right opportunity comes along before
making a stock purchase and then owning shares of stock in a company for
a long period of time to allow his investment thesis (i.e, the reasons
why he likes the company and purchased the stock) to be borne out.
Buffett tends to stick to investments where he can understand the
business the company is in well enough to make thoughtful and
independent decisions. For example, he personally is uncomfortable
owning technology-oriented companies as he does not feel he understands
the products these companies make (nor trends in the broader industry)
well enough to make smart investment decisions. Buffett's investment
approach is probably best categorized as a
"growth-at-a-reasonable-price" strategy. Some people consider Buffett to
be a value-oriented investor, given his tendency to buy shares of stock
in companies when they appear to be "bargains" but Buffett is careful
to avoid companies that do not appear to have bright prospects for their
future earnings.
When Buffett discusses his investment philosophy he will highlight
several things he is looking for in a company that he wants to invest
in. The following include some of the most important things he looks
for:
a) "A durable, competitive advantage." By this
Buffett means that he wants a company that is relatively difficult to
compete against; hence it will likely be able to sustain a high profit
margin over time. Companies which have strong brand-name products (e.g.,
Coca Cola, Proctor & Gamble), or have patent protections
on their products (pharmaceutical companies), or have very strong
customer loyalty and high customer retention rates tend to have a
"durable competitive advantage" over their competitors.
b) A competent and honest management. For obvious
reasons, Buffett is only interested in investing in companies for which
he respects and trusts the key managers of that company. An incompetent,
and especially a dishonest, management team at a company can spell big
problems and Buffett wants nothing to do with investing in a company
where he has reason to doubt the abilities, strategies, or ethics of the
managers of the company.
c) Pay a "reasonable" price for a stock. An
indication of Warren Buffett's patience as an investor is that he
refuses to overpay for a company's stock. While he may love the company, if the price is not right, he will not like the stock
and seek out alternative investment opportunities or wait until the
stock price becomes more attractively priced. Nevertheless, Buffett is
not a cheapskate. A well known quote of his is that "it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
This is spoken like a true GARP investor: Buffett is willing to pay a
reasonable price for a company with great future prospects and would
choose to invest in such a business over a company that has a cheap
stock but only modest potential for improved future earnings.
Another key to Buffet's success is his temperament. He seems much
better than most investors at staying calm when others are panicking
over short term concerns about the stock market or a particular company.
In fact, Buffet welcomes it when other investors are very worried, as
it may create potential to buy companies that others have hastily sold.
Another famous quote of his is as follows: "You pay a very high
price in the stock market for a cheery consensus. Uncertainty is
actually the friend of the buyer of long-term values."
6. Don't take a big loss.
Another piece of important advice from Warren Buffet, considered the
greatest investor in modern times, it to make sure to avoid taking a big
loss. If an investor loses half of his money on a bad investment
decision he must then double his remaining money to get back to even. In
other words, a loss of 50% requires a 100% gain on what remains in
order to return to the original amount. The best way to avoid taking a
big loss is to avoid investments that hold great risk. If you do invest
in something risky, it may be advisable to sell the stock if it begins
to drop significantly in value in order to better preserve one's
investment capital.
Warren Buffet's first rule of investment is "Don't take a big loss." His second rule of investment is: "Don't forget Rule #1!"
A corollary to Buffet's rule is a piece of advice offered by Jim Cramer of the CNBC show "Mad Money": "Ring the register; no one ever lost money taking a profit." In
particular, he directs this advice to investors who have seen shares of
stock they own go up significantly in value. It may not be necessary to
sell all shares, but it is a good idea to sell some shares in
order to ensure that you realize a profit. For instance, if a stock
doubles in price, some investors will sell half the shares they own,
thereby recovering their initial investment and knowing that the
remaining shares they own represent pure profit. Such a disciplined
approach in taking profits helps to protect investment gains. However,
it is a good idea not to reinvest the proceeds of such sales in
companies within the same industry (e.g., selling stock in one energy
company, then buying another company in the energy industry) in case the
entire industry runs into difficulty and the stock price of all
companies in that industry go down.
7. Be aware of your emotional tolerance for losses
Typically, the stock market goes down in value a lot faster than it
goes up. Months of gains in the stock market can be wiped out in the
span of several trading days if there is significant new developments
that cause investors to rethink their investment strategies. For most
people, the agony of losing money through investing is worse than the
pleasure gained from making money. Understand your ability to withstand
temporary investment setbacks and do not exceed your tolerance for
volatility and risk. If a person does exceed his or her tolerance, he or
she will be much more likely to sell at the first moment of panic when
smart investors are "averaging down" (accumulating more shares of stock
in a company at a lower price).
The stock market swings between extremes of human greed and fear. The
best investors recognize these extremes and try to take advantage of
them. Always set aside some of your investment money in the form of
"cash" for extreme events that cause the stock market to significantly
sell off. Such a cash cushion allows investors to better weather a
market downturn and to take advantage of companies that suddenly see
their stock price drop for no good reason due to widespread investor
panic. Taking advantage of a good buying opportunity when many other
investors are fearful is only possible if you yourself are not also in a
panic. Be aware of the extreme emotions of greed and fear in yourself.
Succumbing to either these emotions (selling due to fear and buying due
to over optimism and greed) is the cause of a lot of investment
mistakes.
8. Dividends are important.
Dividends can play an important role in terms of one's success
investing in stocks. Companies that pay dividends tend to be more
established and have stable earnings than companies that do not pay a
dividend. If you select stocks to invest in that pay dividends, you will
find yourself gravitating toward safer, stronger companies. In
addition, dividends provide current income to an investor. Dividends can
add to one's overall gains (the profit from an appreciation in the
price of a stock from what you paid for it) or offset losses. Another
important quality to dividends is that they can grow over time and can
come to represent a very significant component of the benefit of having
invested in a particular stock. For instance, if a company increases its
dividend each year and one owns the stock for a long period of time,
the dividend yield (the amount paid in dividend each year divided by the
stock price) can grow to be quite significant, particularly with regard
to the original price paid for the stock. Finally, most dividends are
taxed by the federal government at a rate of 15%, which is lower than
the tax rate on earned income for many tax payers.
9. "Don’t confuse a bull market for genius."
When things are going well in the stock market it is a good idea for
investors to stay modest about their stock picking abilities. A bull
market lifts the stock price of most companies. The general trend of the
market may be more behind an investor's current success than his or her
skill at picking stocks. Conversely, an investor should not be too hard
on him or herself in a bear market when most stocks are going down in
price.
10. Adapt to changing circumstances.
If you come to learn about something new about a company which you
have invested in and it causes you to wonder if you have made a mistake
to purchase its stock, try to differentiate between temporary problems
that can be corrected and more serious developments that may permanently
reduce a company’s earnings. If a problem seems temporary in nature, it
may be smart to hold on to the stock or even to buy more shares if
other investors have been too quick to sell it. If the problem is most
likely permanent, probably the best thing to do is to sell the stock and
reduce your loss (or preserve your gain).
An easy "mistake" to make is to invest in a company that make products
(or provides services) that can be made obsolete by newer technologies
which come along. When a new technology develops or something else
changes in a significant way that will harm the future earnings of a
company, it may be wise to see the "writing on the wall" and sell the
stock. Circumstances change and developments emerge that were not easily
foreseen. All good investors take in new information and reassess their
investment decisions based on new facts. Good investors force
themselves to "listen to what they don't want to hear." In other words,
if there is bad news about a company, it should be acknowledged and one
must then think about the long term implications such news has for the
earnings potential of the business.
