Finally, we have gotten through the fundamentals of the stock market. I have driven home the point of the great benefit of investing in it. Hopefully, I haven’t bored you in the process – God forbid. But when you are trying to convince people to do something, especially when it involves a lot of money and time, you better have a good rationale for why they should listen to you.
Now that I have successfully convinced you to open up that brokerage account and put a thousand dollars in there to trade, I better give you a few rules on how to invest so that you don’t cash out with less than you started with and then blame me for all your misfortunes.
Again, it’s okay if you want to take the mutual funds route or keep your money in a savings account. There’s nothing wrong with earning risk-free interest. Just don’t expect to become a millionaire by investing in CDs and treasury bonds.
However, for all of you that are not risk-averse, there’s a lot of money to be made in individual stocks and I want you to take the journey with me. I am going to try to provide you with my one-and-a-half years of “wisdom” on individual stock investing that has helped me limit my losses and maximize my gains.
Rule 1: Don’t invest a single penny into the stock market until you really know what you are doing.
You cannot just have a cursory knowledge of the stock market. You have to really know how the stock market works. Overall, you first must understand that stock prices are driven by supply and demand in the market for that given stock.
Moreover, you must understand how to look at the fundamentals of a stock: the price-earnings ratio, the book value, the return on equity and the profit margin.
Price-earnings ratio is the amount a shareholder pays for each dollar of a company’s earnings per share. Book value is the assets minus liabilities and is also called the shareholder’s equity. Return on equity is the net income divided by shareholder’s equity.
You should also understand that the true value of a company is not its stock price, but its earnings, its tangible assets, its growth prospects and so on.
Spend some time educating yourself before you press the trade button.
Rule 2: Investing in the stock market can be like gambling if you don’t make wise decisions.
For example, while there is risk inherent in all levels of the stock market, the risk is greatest in small cap speculative stocks, which have a market capitalization between $300 million and $2 billion, as well as mid-cap speculative stocks, which have market capitalizations between $2 billion and $10 billion. If you bank your entire portfolio on these obscure small caps or mid-caps, you are pretty much gambling.
Rule 3: The stock market is sometimes irrational.
This is especially true in the short run. Sometimes, more often than I like, the directions of stocks may not make a lot of sense. A company may see its share price decline for no reason. Another company may report terrible earnings, but its share price may move significantly higher.
The lesson from this is not to get caught up in the irrationalities of Wall Street. You don’t have to follow the herd of idiots.
Rule 4: Diversify! Diversify! Diversify!
I hope the repetition has engrained this concept into your mind forever. You cannot invest your entire stock because it’s got great prospects, it’s going to be the next big thing or it’s going to beat the S&P for years to come. A stock may be great now, and it might have great prospects, but anything, and I mean anything, can happen in the future. Look at Enron. If that was the only stock investors held in their portfolio, they got massacred. The stock’s completely worthless today.
Also, you can’t just invest in one sector. Think about the tech bubble. Double digit gains turned into painful losses. However, if they had only had a percentage in tech, their entire portfolio wouldn’t have been wiped off. Remember, it’s hard to start over with nothing.
To be fully diversified, you must invest in several sectors. These sectors should not be correlated to each other. That way, a downturn in one sector may only affect one or two stocks in your portfolio.
Rule 5: Don’t take the word of the analyst or the financial pundit as the gospel.
If you invest in a stock just because of a recommendation from a Goldman Sachs analyst or Jim Cramer, you deserve to lose every cent of your money. That is just plain stupid. Would you also jump off a bridge if Cramer asked you to? Don’t answer that.
I’m not saying to completely ignore the analysts or experts. They can have good ideas. But they also have some bad ones, and quite honestly, they don’t always know what they are doing. That is why you have to do the research to determine if a recommendation merits investment.
Personally, I’ve gotten some good stock ideas from the analysts at morningstar.com, but I always did my homework before I bought.
Rule 6: When you have significant unrealized gains in a stock in a short period of time, sell it and take the gains.
There’s got to be a compelling reason for you to hold on to the stock when you are up 20 to 50 percent in a couple of months. Unless you really have strong reason to believe that the stock is still undervalued, you should sell and be happy with the gain.
I know from experience. My first invest-ment was in Petmed Express. After a few months, I had a 30 percent unrealized gain. I was on top of the world. Then out of nowhere, the stock went from $20 to $10. Boy, did I wish I had sold. If I had known more about stocks and investing – yes, I was also breaking Rule 1 – I would have realized the stock was overvalued. Losses are much more painful than selling a stock before a run-up. Oh well, I guess my mistake is your gain.