Investing and trading securities are two different activities. Both have the objective of making money, but the approach is very different.
The Investor’s objective is to make a large profit over a long period of time. They will buy stocks, ETFs and other assets that are a good value based on the fundamentals of the business and the market. The general strategy is to buy and hold because the fundaments are strong. Investors also have the ability to ride out the market swings and perhaps add to their positions in the downturns. The most famous value investor is Warrant Buffett and his investment company Berkshire Hathaway.
Traders will buy and sell the assets with the objective of making profits more quickly and have a short defined holding period. They often employ a wide variety of tools to make money and moderate the risk, which includes short selling and options. George Soros is famously know as the “The Man Who Broke the Bank of England” for his short sale of the British pound in 1992 that made his hedge fund a cool $1 billion profit.
The average person that invests money is realistically an investor. They may dabble in some trading but the majority of their hard-earned cash is invested in long-term assets. Do you remember the children’s story of “The Tortoise and the Hare”? The tortoise beat the hare in the race. Warren Buffet has a net worth of approximately $101.2 billion, whereas George Soros is worth about $8.6 billion. You have to love the investor’s value approach.
Here is my collection of the top 10 rules for investing:
- “Rule #1: Never lose money. Rule #2 Never forget rule #1”. Warren Buffett is famous for this pair of rules. Many other famous investors have stated the same idea in different ways, and it is the basis for other rules of investing. Before buying any company, Buffett thoroughly researches the company, understands how it makes money, and understands its value proposition. Buffett buys healthy companies that have great long-term potential. When you take this approach, you maximize your prospects for long term success. You worked hard for your money so do not gamble it way!
- Diversify your portfolio. Every successful investor has investments in a variety of industries. No one can predict what will happen tomorrow and by having investments in a variety of industries and sectors you minimize the risk of being wiped out because you had all your eggs in one basket. If you are investing in the stock market the easiest way to achieve this is by buying some Index ETFs or buying a few ETFs in different sectors. Jim Cramer outlines the concept of diversifying your portfolio in detail in his book ‘Real Money’ and ‘TheStreet’.
- Do your homework. Jim Cramer has made this concept popular on his show and in his books. You need to be able to able to explain these 3 things: how a company makes its money, how the industry operates, and what makes it the best company in its industry. If you cannot explain these concepts, then you have not done enough research. Once you have made the investment, you need to keep up with what it is doing. Maintenance is just as important. This way you understand whether changes at the company, regulatory environment or other factors can be of benefit or risk.
- Pick the Best in Breed. By picking the best companies in great industries you maximize you chances of long term success and you sleep easier at night. This concept is reflected in Warren Buffett’s rule “If the business does well, the stock eventually follows.” This ties in with the next rule.
- Buy Damaged Stocks, Not Damaged Companies. I like this rule from Jim Cramer. It is similar in concept to one of Warren Buffett’s golden rules of investing: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Warren Buffett has had tremendous success in knowing the difference between a company that has real problems vs. one that is just not popular. When you have a fundamentally strong company that is just out of favor, you will have the opportunity to pick it up at a reduced price. Eventually, the market will recognize its value again and the price will go up. It is a terrible idea to invest in a company that has gone bad just because its price is low. If you already own a company that has fundamental problems, then cut your losses.
- “Cut your losses short and let your winners run.” This is famous Wall Street saying that many investors do not practice very well. On the upside, review to see if the investment with higher than expected gains has become detached from its real value because of a frenzy. You may want to lock in some of your gains and wait for a pull back, or rebalance your portfolio. On the downside, you need to be honest with yourself and get out of bad situation or mistake as quickly as possible. A great tool to not only lock in gains when a stock changes direction but to also limit the downside of a new investment is by using a “stop loss” order. The are different theories about what percentage the loss should be capped at but I found a great article by David Saito-Chung in Investor’s Business Daily where he outlines the math behind why you should sell a stock when it’s down 7% or 8% from your purchase price. I agree with his logic that this is a good time to cut losses to preserve your capital. The math is even more compelling to let go of the losers the further they drop. If a stock is down 50% you will need it to go up 100% to get back to even. Be honest at that point it is unlikely to happen. If 70% of the investments you own made a modest 25% and you keep the losses to 8%, then your overall portfolio is still up over 15%. None of the great investors have perfect investment records.
- Be prepared for market declines and pounce on them. I like the way Motley Fool outlines the concept that……”You have to expect 10% drops from the entire market about once a year on average, with 20% declines every four or five years. Even bigger crashes of 30% to 40% come at roughly 10-year intervals. We think investors have to stick with great companies through tough times to maximize your long-term returns. It’s even better if they’re able to add money to their winners along the way.”
- Make regular contributions to your investments. The discipline of investing money regularly, like every month, into your selected investments is not only a great way to ensure continual growth, but it also reduces the emotional aspect of investing.
- Create, Follow, and review your investment goals. You need to outline the basics like: how much money do you need for different life events; ensure your portfolio is diversified; your risk tolerance; and what are the expected returns on the investments. There are some great books that outline detail this and I have them listed at the end of the article.
- “If you like spending six to eight hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds.” Another great quote from Warren Buffett. He made a very famous million dollar bet with a hedge fund, by the name of Protégé Partners LLC, that they could not beat an index fund tied to the S&P 500 over a 10 year period. At the end of that 10 year period the index fund won. The fund Warren Buffett selected was the Vanguard 500 Index Fund Admiral Shares (VFIAX). Index funds have been a great way to keep your money growing at a similar rate to the stock market.
My list is by no means comprehensive, but I hope this will give you a great starting point to successful investing.