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.