Investing in the stock market is easy in theory: simply buy-and-hold for the long term and bet on the US economy. So says Warren Buffett.
In practice, it’s so much harder. The fastest decline in stock market history was recorded in the first quarter of 2020 following the outbreak of COVID-19.
For investors to stay the course while watching portfolios crash ever deeper into the red is no mean feat. Here are stock investing tips to help you prepare for stormy days and prosper long-term.
Table of Contents
- Stock Investing Tip #1: Prepare For Stormy Days
- Stock Investing Tip #2: Avoid Panic Selling
- Stock Investing Tip #3: Buy Intrinsic Value
- Stock Investing Tip #4: Track Your Financial Goals
- Stock Investing Tip #5: Focus On Financial Metrics
- Stock Investing Tip #6: Manage Risk
Stock Investing Tip #1: Prepare For Stormy Days
As stock markets hit higher highs, you can feel like the winner at Casino Royale cashing in your chips. And at market lows, the stock market can make you feel like you got duped in game of three card monte.
The challenge is to ride out the storms and anticipate them when the sun is shining. Not everyone can generate market-beating returns for half a century like Warren Buffett did, but at the very least you should be able to earn returns in line with the stock market – a feat most investors fall short in achieving.
So, how can you succeed where most investor fail?
Begin by preparing for those stormy days that inevitably lie ahead. That means creating a disciplined investing plan that you stick to no matter where share prices move.
The tried and trusted method of investing is to dollar cost average into the an index like the S&P 500 over time.
Rather than time the stock market highs or lows, invest a steady amount each and every month year after year. That has proven to be the the best investing tip to create wealth over the long term.
You won’t buy the bottom or sell the top using this method, but equally you won’t miss out on huge gains by attempting to time the market.
Stock Investing Tip #2: Avoid Panic Selling
Human minds are a powerful thing, but they sure do have a habit of sabotaging us from time to time thanks to cognitive biases.
Prospect Theory is a Nobel prize-winning theory that explains how we humans hate to lose more than we enjoy winning.
When stocks fall, it hurts us more to lose money than it gives us pleasure when they rise and we make money. As stocks fall further, the pain of loss grows and it is easy to hit the panic button and sell – because it eliminates the pain of further losses.
It is especially easy to panic and submit a sell order with your broker when the money you are trading is money you need to live on or expect to use to pay bills in the near future. But what if you didn’t need that money? Would it be easier to ride out a stock market storm until sunny days returned?
But What If The Stock Market Crashes?
Successful investors have seen the ups and downs of the stock market, so even a stock market crash tends not to phase them a whole lot.
In fact, they often pounce on stock market declines as opportunities to buy value stocks. They have the luxury of knowing they don’t need to sell stocks to pay the bills. So how do you avoid the pitfall of panic selling like rich investors?
Define clearly what money is needed to cover your expenses, including an emergency fund, and provide a cushion room for day-to-day living costs in case you lose your primary income stream.
Label your money and bucket it into categories. Once you know how much you need to pay for current and future bills, add a cash savings buffer which will give you peace of mind knowing you can dip into it if you lose a job, and then ask yourself whether any of that money is invested in the stock market.
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Any money that is assigned to cover bills, tuition expenses, day-to-day costs and other living expenses should probably not be invested in a concentrated portfolio of equities.
If you are retired and enjoying dividends or yield from bond investments that’s another story. But if you have money you need soon tied up in a portfolio of risky investments, then take a step back and think realistically instead of optimistically.
Optimistically you might believe you have the intestinal fortitude to handle a stock market crash, but Prospect Theory predicts you might hurt more than you think, which means you might get trigger happy and sell the dips precisely when stocks are on sale.
Rich investors are like predatory bears upstream just waiting for you to swim by and eat you for lunch, or at least your assets. They will be happy to take your money from you by buying the shares you may be selling at bargain basement prices.
By bucketing your money into different categories, you will avoid the temptation to over-commit to investments. Instead, allocate only what you can afford to lose to your brokerage account.
At the very least, sum up your total liquid assets to get a handle on the size of your pie and then consider how much you need to allocate to:
- Mortgage or rent costs
- Grocery and food costs
- Entertainment and vacations
- Utilities and cable costs
- Emergency fund
- Auto and fuel costs
- Insurance costs
The last item on the list is investments because it is imperative that you cover the necessities first: food, housing, auto, and insurance.
Stock Investing Tip #3: Buy Intrinsic Value
Are you a professional investor or a speculator? Do you really know what your buying? The answer to those questions is at the heart of understanding intrinsic value.
Share prices are quoted so widely that investors often use them to make buy and sell decisions. But what information do share prices really convey?
Prices are quoted on financial news networks daily and spotlighted when earnings soar or plunge so it’s easy to be distracted by them.
When you log in to your brokerage account, share prices are listed in your stock watchlist. And when takeovers occur, it is often the skyrocketing share price of the acquired company that grabs headlines.
A share price doesn’t convey the true value of a company. Nor does it offer you any insight into where the company is headed. From a share price you can’t discern whether competitors are sneaking up on the company and about to steal its market share.
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Technical analysts and chartists may find value in analyzing share prices by comparing price levels to support and resistance, moving averages, and overlaying chart studies, such as MACD and RSI indicators. But if you are not an avid trader tied to your desk daily watching every tick what should you do?
Focus On Intrinsic Value
Where share prices are highly visible, intrinsic values are virtually invisible to most casual investors. Hedge funds, institutional investors, and Wall Street analysts pay a lot of attention to intrinsic values because they convey much more information about where a stock price may be headed than do share prices themselves.
Think of share price as the moth and intrinsic value as the flame. In the darkness, the moth may fly up and down, circle around and back, weave left and right but when it sees the flame it naturally is attracted to it.
Similarly, share prices may undulate from one moment to the next and from one week to another with a seemingly random pattern, but a force attracts them, called intrinsic value.
When you examine share prices over time, it may seem to defy logic why some companies stay still while others march higher.
But the mystery can be solved easily.
Companies with increasing intrinsic values generally enjoy rising share prices over time. Risk of corporate governance issues or other outlier events is always a risk but for the most part, share prices track intrinsic value over the long term.
Intrinsic value is also known as fair value, and it can be calculated using a discounted cash flow forecast. Here is the fair value for Alphabet Inc. or Google as it used to be known.
So, the key stock investing tip when you are making buy and sell decisions is to focus on intrinsic value much more so than share price. By doing so, you can make more informed decisions.
After all, if you know a company has an intrinsic value much higher than what its share price reflects then you will be less likely to view it in a negative light and offload it when it may be on sale.
Plus, you will be more likely to make a rational decision about where it is headed over the long term.
Stock Investing Tip #4: Track Your Financial Goals
Can a sports athlete help you think about investing better? Perhaps…
Over a 5 year period, mixed-martial arts fighter, Conor McGregor, went from paying his bills from social welfare income to making hundreds of millions of dollars.
But how did he do it?
Talent is only part of the answer. McGregor says the reason he became so successful is his greater work ethic compared to that of fellow combatants.
He explained how his philosophy of hard work extended beyond physical sessions in the gym. After each sparring session and each wrestling or jiu-jitsu clinic, he took copious notes about what he did right and wrong, and how he could improve.
From his reflections, he learned to improve so that he could move closer to his goals.
Successful stock market investing requires this level of introspection too in order to prosper and meet your financial goals.
What investments made money and which trades lost? Did you buy too much all at once because you got greedy?
If so, what rule can you put in place to lower your initial risk? Perhaps you can buy via dollar cost averaging instead of all at once.
Did you panic and sell when prices dipped only to see them recover to higher highs? Determine the reason behind each purchase and sale order.
Maybe you had too much on the line, and couldn’t stand the pain of losing more. Should you consider hedging your stock portfolio with married puts to limit risk? Would that give you more peace of mind?
If you have a regular stock brokerage account and don’t understand options trading, maybe the investing lesson to learn is how to trade options. Perhaps you could consider opening a demo account on an options trading platform, such as thinkorswim, so you can begin practicing.
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By tracking your performance, measuring the results, reporting your gains and losses monthly and documenting the investing lessons learned, you will be on the path to iteratively improving so you can better achieve your financial goals.
Stock Investing Tip #5: Focus On Financial Metrics
Sometimes the 10,000 foot view of how you spend your time can be eye-opening when it comes to building wealth.
For example, consider how many hours you worked to build up your nest-egg.
Now think about how many hours you dedicate to choosing investments for your hard-earned dollars.
If you’re like most people, the time you spent building your savings can be counted in years and decades while the time taken to allocate your money can be counted in minutes or hours.
But common sense says you should be diligent about researching how you invest your money.
To understand what you are investing in, start with the financial metrics. You don’t need to open up a spreadsheet and get too crazy, but at the very least take a look at some important numbers.
In the stock chart below, you get to see the historical revenues for Amazon.com. Revenues are helpful in giving you the 10,000 foot view of where a stock has been, but it doesn’t offer any insight as to where it may be headed.
To know where a stock could be headed next, future earnings growth expectations can be used to place a stake in the ground. When earnings are growing rapidly, share prices generally move higher over time.
A quick glance at the balance sheet will tell you whether your company, like Amazon, is debt free or has a high debt to capital ratio. Companies with high debt levels may suffer more during high interest rate environments.
After viewing some of the basic financial metrics on the balance sheet and income statements, glance at share price history to see how volatile it has been historically.
Even a solid company may not be appropriate for your risk profile if it has a history of wild swings up and down.
Above all, what you want to glean from your research is the fair value of the company.
Share price tells you what price you will buy or sell, but fair value is much more insightful – it can offer insight into where a stock may be headed next.
Stock Investing Tip #6: Manage Risk
It is with good reason that Warren Buffett has described the first rule of investing as not losing money and the second rule is to not forget the first rule.
Lose just 10% of your portfolio and you need to make an 11% gain to get back to breakeven. Lose 50% of your portfolio and you need to generate a 100% return to get back on an even keel.
The percentage you need to gain after losing money is always larger than the percentage you lose to get back to where you began because, after a loss, you have less money to play with.
This focus on risk is contrary to our human nature. Our tendency is to keep our eyes on the prize. But earnings handsome returns come at the cost of ever higher risks.
When an investor gleefully claims to have generated a 100% return, the real question is how much risk was taken to achieve the high return?
Professionals focus on risk-adjusted returns with good reason. Generating high returns is not the biggest challenge to overcome but generating high risk-adjusted returns, that’s a whole other ballgame.
At an extreme, you can think about a lottery win. The return is enormous if you win, but what is the risk?
The probability of failure is nearly 100%, so while the reward is alluring it is highly improbable.
In the stock market, focus on your risk-adjusted return more so than your absolute return, and you will be one step ahead of much of your competition.
What stock investing tips have you learned? Share your investing stories with us in the comments below. We would love to hear from you.