Strategies for Investing in Stocks
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.
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.
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.
4. "Growth at a reasonable price" investing.
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.
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:
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.
6. Don't take a big loss.
7. Be aware of your emotional tolerance for losses
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.
9. "Don’t confuse a bull market for genius."
10. Adapt to changing circumstances.
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.