Think of investing as a sport or game. You have competitors and competing interests. There are different strategies to “winning.” You have laws, regulations and rules everyone must play by, yet there are always a few cheaters looking to get an edge.
If you plan on being competitive and not losing all your money, it is important you develop your own set of rules to investing. These rules will serve as basic principles for your investing philosophy, thereby providing you guidelines on the types of stocks and companies to buy, when to divest shares, how to view market volatility, etc.
Bulls and Bears Make Money, Sheep Get Slaughtered
If you are new to investing, a “Bull” refers to an optimistic investor who believes the stock market will go higher while a “Bear” believes that share prices will fall. This rule refers to the fact that, like all business endeavors, earning a higher return than the market average requires splitting from the herd and making unique investment choices.
Generally speaking, when markets fall, institutional or professional investors are the first to get out, leaving retail investors to catch the falling knife. Then when the tide is turning, stocks have bottomed and sentiment is on the cusp of turning positive again, institutional investors again are the first to scoop up shares at a discount, allowing them to earn outsized returns and beat the market.
Don’t Worry About Taxes, Worry About Losses
It’s always interesting when people claim not to engage in a profitable endeavor because the taxes they will end up paying. The simple question is – are you not going to earn $1,000 in capital gains because you may end up paying $200 in long-term capital gains taxes? That’s ridiculous. Earn the $800 in net proceeds, pay your $200 in taxes, and say “Thank you very much.”
Instead of worrying about taxes, you should be concerned about losing money. While losses can lower your taxable income, unless you’re wealthy and need a tax-loss harvesting strategy, don’t lose money. Ever. Period.
Losing capital provides you a smaller base to invest with. The obvious example is that earning 10% on $100,000 is significantly more than earning 10% on $90,000 because you lost 10% of your portfolio last year.
Diversify to Manage Risk, But Control Costs
There are several ways to diversify risks, including investing in different asset classes, industries, and stocks. You can achieve this through index funds or well-researched “bets” on specific, individual stocks. However, over-diversification can also be costly or even create drag on your investment returns.
One strategy can be to take advantage of free offerings from different discount brokers. For example, an Etrade review would uncover that the brokerage house offers over 115 commission-free ETFs, so a portion of your private portfolio can be in an account with them. Simultaneously, the bulk of your funds might be with Vanguard to take advantage of their passive index funds, many of which charge less than 0.25%.
Another strategy to control costs and augment returns may be to explicitly avoid high-cost brokers. The SEC has conducted research indicating just how much a small increase in costs can affect a portfolio over time and the results were huge. If a low-cost approach is essential to your stock trading, then you may want to compare TradeKing vs Scottrade, two of the cheapest commission online brokers.
Buy Under-Performing Stocks, Not Under-Performing Companies
As Warren Buffett once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” In the long-run, the difference in performance between great and mediocre companies grows larger, until eventually, poorly run companies disappear.
However, this rule refers to the fact that the best investors try to find inconsistencies in the market, usually in cases where investors are overlooking or discounting the future performance. This price disparity is often driven by fear or some type of emotion.
The best example is Apple’s stock between January 2013 and April 2014. During this time, Apple was trading between a split-adjusted price of $55 and $75, despite nearly one-third of the company’s value, or approximately $150 billion in cash, sitting on the balance sheet. This price range gave Apple a rough P/E of 6 while similar companies such as Microsoft or Google were valued at much higher valuations.
As market sentiment shifted and investors realized their irrational fears over Apple’s business model, the stock price started to increase. In May 2015, the price peaked at over $130 per share. While Apple did not transform overnight, investors who realized this pricing discrepancy and had the patience to see it through were rewarded.
It’s OK To Have Cash
Many investors feel the need to always be completely invested. Unfortunately, this leaves little dry-powder for opportunistic buying when prices fall and bargains appear. If you believe the market is overbought and risk isn’t fully priced into the market, it may be a good time to sell and wait for prices to fall. Having a contrarian view can sometimes create the best buying opportunities.
Life Insurance Is Not An Investment
While this is not a direct investment strategy for the stock market, it is an important general financial planning concept – do not use permanent life insurance policies to indirectly invest in the market.
Some financial advisors tout whole and universal life insurance policies as ways to get life coverage and also grow their investments. The logic behind this concept is that term life insurance expires and policyholders get nothing in return, whereas permanent policies build cash value. Whole life pays a flat interest rate, after administrative and mortality fees, and universal life allows premiums to be invested. However, neither universal nor whole life insurance as an investment makes sense, and this article explains why.
Buy a term life policy, invest the difference in a passive index fund, and you will avoid making your financial advisor rich off commissions while you earn sub-par returns.
In the end, there are no concrete rules to investing. Each investor has different financial and investment goals, strategies, comfort levels for risk, etc. Ultimately, the more you research and learn about the stock market, investing, and portfolio management, the more empowered you will feel when making decisions so grow your knowledge base and decide what works best for you.
Author Bio: John Schmoll and Gary Dek are former finance professionals who are committed to helping new and seasoned investors make smart investment decisions