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Key Investing PrinciplesWe have compiled the following list of investing principles, tips and advice that will help you make money in the stock market. Our recommendations are based on our investing experience, research and real data. A capsule listing of these recommendations are also listed in a table format. To jump to a section in the article, click on a link. Have a Plan Before you start to invest money in the stock market, you need to develop a long-term savings plan and a long-term investment plan. The plans have different objectives. Your savings are the difference between your income and expenses. A savings plan sets aside money for different purposes, one of which is long-term investing. The saving plan determines how much money you have to invest - all or part of your savings is the input to your investment plan. The investment plan makes the savings grow over time. If you are investing for your retirement, read the articles in Retirement Investing. The Overlap of Your Investing Experience and the Ups and Downs of the Market If your investing career coincides with an up trend in stock prices, you have a good chance to make money. You make money simply because more stocks are going up than going down, so you catch the money-making wave when many stocks move up together. In sustained up markets, investors of all stripes make money because buying and selling on the upside is a winner's game. On the other hand if you invest when the market is in a long-term down trend, you probably will have small gains or lose money. No amount of investing skill and experience can fully counteract the negative effects of a multi-year down market. Losing stocks overwhelm winning stocks, so it's very difficult to make money. Buying and selling on the downside is a loser's game. Reminders:
Make Projections About the Future Direction of Prices History confirms that stock prices move in up and down. For cyclical stocks the up and down moves occur with some regularity. Broad market averages like the DJIA, SP500 and Nasdaq have patterns of multi-year up moves followed by multi-year down moves. You need to know where you are in these cycles because some investing strategies work well in an up trend but do not work in a down trend. Study price patterns of many individual stocks and stock market indices to learn to spot up and down moves. Price charts are visual records of the price action for a stock. A price chart is to an investor what an x-ray is to a physician. With charts you can make educated guesses where prices are likely to go in the future. Obviously predicting future prices is a very difficult task but at a minimum you want to be able to say that you think prices are going up, staying flat or going down. You don't have to know how high or low but you need to estimate the general direction of price movement. Reminders:
Understand What Can Go Wrong and Limit Losses You can make significant money in the market, but you can lose lots of it as well. You can buy the stock of a poorly-managed company, buy the stock of a good company but pay too much, buy on the downside, borrow money to buy a stock and then have the stock price collapse, or have a totally unexpected event crush the stock. Bad things happen to investors. Very few, if any, investors are immune from losing money from time to time. For example, you turn the TV on and learn your favorite company is down 60% that day because they just announced an unexpected accounting irregularity. No amount of due diligence on your part could have prevented the stock collapse. It just happened. If the stock accounts for a small percentage of your portfolio, you're unhappy but the financial damage need not be significant. But if the stock is ninety percent of your holdings, your loss is significant. You must learn to guard against situations that can lead to sudden financial pain or long-term ruin. Before you commit money to an investment, always think about the worst-case scenario. Always ask: "What happens to my financial security if I lose every dollar I put into this investment?" John Bogle, the founder of Vanguard Investments, put it succinctly. " Uncertainty is the possibility that you will lose a lot of money just when you need it most." Reminders:
During your investing career you'll receive lots of advice from friends, family, colleagues, radio and TV, book and magazines, brokers and money managers. Some of the advice is sound and a lot of it is pure junk. You have to know the difference. Remember that when you make a decision to buy, sell or hold that it's your financial well being that's at stake. It' s your money. Therefore, don't be in a great hurry to part with your money just because another person recommends a stock. Reminders:
Investors who lived through the 1982 - 2000 bull market were conditioned to buy. They bought at almost any price and most were rewarded. The "Buy Wall Street Propaganda Machine" was in high gear and investors responded by pumping trillions of dollars into the stock market. Buying on dips in price often paid off because the market was on the upside for 12 years. Even as the market spiked up and began to fade in 2000, the "Buy Propaganda Machine" said: "It's different this time - keep buying." And people kept buying only to see steep declines in the next few years. Recall the 1929 compulsion to buy, which led to money-losing investments for the next 25 years. Investors who bought the Nasdaq bubble in 1999 and 2000 will wait years before they break even and during that time inflation will eat away at their investments. Reminders:
Carefully Select Buy and Sell Prices Buying and selling stocks at the right prices determines your financial gains and losses. The art in buying a stock is not to pay too much and the art in selling is not to receive too little. CTM shows you that the percent winning trades on the upside is in your favor but the percent winning trades on the downside is stacked against you. It is very difficult to make money when you buy on the downside. Buy on the upside and never buy on the downside. Use The Price Direction Indicator (PDI) and CTM to identify upside prices and downside prices. Consult Making Buy Decisions, Making Sell Decisions, the Buyer's Checklist and Seller's Checklist for more tips about buying and selling stocks. Reminders:
Diversification Does Not Always Protect You from Losses Some diversification is good because owning several stocks helps soften the blow if one or two stocks suffer. But too much diversification is counterproductive because owning too many stocks means you'll have losers and well as winners. Diversifying in a single sector, for example, telecommunications, doesn't give much protection because the stocks in that sector are highly correlated so when one goes down they all tend to go down. Read the articles in Sample Portfolios for examples of stock portfolios. Reminders:
Dollar-cost Averaging Does Not Always Lead to Profits When you dollar-cost average, you invest a fixed amount at a regular interval no matter what the stock price. Dollar-cost averaging is a systematic investing method that helps you make money if the stock is in a long-term up trend. However, if the stock goes into a prolonged downturn, dollar-cost averaging will not ensure that you make money. Yes, you buy more shares as the stock prices decreases, but if it keeps going down, your accumulated shares decrease in value. You may end up with a loss. If the stock continues to slide, simply stop buying it and wait until it starts to recover. That way, if the stock is in a very long-term slump you have not committed fresh money on the downside. Reminders:
Holding Stocks for a Long Time Does Not Always Ensure Gains Conventional Wall Street wisdom says to buy-and-hold stocks to capture long-term gains. The buy-and-hold strategy says to buy stocks and then ride out the ups and downs in prices. Because the long-term price pattern of the broad U.S. stock market has been a long-term up trend, you will be rewarded in due time. But the individual investor doesn't have an investing career of hundreds of years. Your returns are determined by the price moves for a much briefer period. As such, your returns can be well above or well below the long-term average returns. So long-term average returns for the market based on hundreds of years of performance data have little meaning for individual investors. The problem with the buy-and-hold approach is twofold. First, if you start your investing career paying high prices or buying at the peak and then enter a multi-year down trend in prices or a period of stagnant prices, you may not break even for years and may never accumulate much profit. The second problem is you may not live long enough to benefit from the up trend if your investing period coincides with a multi-year period of down prices. However, if you are fortunate to start investing in a period of low prices at the start of multi-year up trend, you can benefit from the buy-and-hold strategy. Reminders:
Dividend Reinvestment is an Easy Way to Increase Your Returns When you buy a stock that pays a dividend, you can receive the dividend in cash, or for most stocks, you can reinvest the dividend to buy more shares. Dividend reinvestment is one form of dollar-cost averaging that we strongly recommend. For many investors the cash dividend would be small because you don't own enough shares to receive a large dollar amount. Therefore, you would probably "waste" the small dividend amount. In this case, reinvest the dividends and increase the number of shares you own. If the stock does well, you'll increase your shares without investing any new money. The dividend is a dollar bonus you receive from the original money you invested, so its not new, out-of- your pocket money. (Obviously if you need the dividends for part of your income, you would not reinvest them.) Reminders:
Read All About Dividends for more information on dividends, dividend-paying stocks and dividend-paying mutual funds. Buy Index Funds if You Do Not Want to Own Individual Stocks If you want to participate in the stock market and you don't want to buy individual stocks, you can buy a mutual fund, which is a portfolio of stocks. A fund can be either managed or not managed. A managed fund is run by a professional manger who buys and sells stocks for the fund. Some managed mutual funds return handsome rewards but unfortunately many managed funds do not perform better than the benchmark S&P 500, the index for the 500 largest public corporations in the United States. So you pay commissions and fees to under perform the broad market. We prefer to buy a non-managed fund called an index fund that tracks a selected group of stocks. For example, the Vanguard Index Trust 500 tracks the S&P 500 index. The fund manager simply owns all stocks in the S&P 500. Because the manager does not have to actively decide what stocks to buy and sell, the fund's expenses are very low. High expenses substantially reduce your gains. For example, assume you invest $10,000 and receive a 6% return each year for 30 years. If you pay no fees, your total amount is $57, 434.91. If you pay a 1% annual fee, your total is $42,484.63, and if you pay a 2% annual fee, your total is $31,329.84. These seemingly small dramatically reduce your total return. Reminders:
Don't be afraid to hold cash, particularly if you are nervous and uncertain about the future direction of the stock market. Remember a down market is not your friend. You don't have to buy a stock just because it's dropped in price. Even if cash doesn't give you a high return, you're not losing principal and you have the flexibility to scoop up true bargains should they become available. You don't have to be "fully invested in stocks " as the Wall Street professionals like to say. Reminders:
Good luck and invest wisely.
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