I invest my fair share in the stock market and have done relatively well in it. However, this is an area where I consider myself underdeveloped.
Because I am always looking to invest the income that many of my websites generate for me and at the same time diversify my holdings, I am always looking for other ways to make my money work for me. The stock market is one of them.
I like this post because it demonstrates that getting great results investing doesn’t have to take a lot of your time. I hope you enjoy the guest post below . . .
This is a guest post by Brett over at the Investing Part Time blog. He has been investing successfully in the stock markets despite not working in a financial career. Brett currently works full time as a litigation consultant, but is also working on several projects right now that he hopes will eventually allow him to work full time for himself.
Despite what most people are led to believe, investing in the stock market doesn’t need to be that challenging. Experts on CNBC and stock websites constantly tell us that it requires tons of work, and that it is best left to the expert money managers.
They advocate you should quietly invest your money in mutual funds for the rest of your life, and hopefully when you retire, it will have grown 8% a year over the course of your career. But what happens when the stock market crashes like it did in 2008?
Experts say it was because of reckless behavior on the part of banks, and so to prevent your portfolio from tanking, you should have invested most of your money in “safe” assets like corporate bonds and money market funds (which at last count paid less than 1% annually in yield—less than inflation, which was about 1.6% in 2010).
If you listen to the experts on TV and the internet, you would have sold all your stocks at the bottom of the market, and then have missed out on the recent gains over most of 2009 and 2010. Reacting to what the market has done in the past is valuable only in the sense that it can teach you.
But rushing towards the latest trend will usually only harm you, because for every average part time investor reading the news on a weekend and seeing a company that has been doing well, there is at least one full time investor who has already acted on that information. I’m not trying to sound fatalistic, but that is an important truth you must realize if you can’t manage money full time.
However, this isn’t the way investing needs to be. You can get great results investing even if you don’t spend tons of time doing it. The foundation you need to have is threefold: start by knowing a few basics, always do your own research, and finally, manage your risk. If you spend a little bit of time each week doing this, I suspect you will be better off than 80% of average investors.
Let’s take a look at each piece in detail.
Figuring out which basics are important is actually harder than you’d think. Do a quick Google search for “investing basics” and you will be bombarded with over 6 million pages of results. If you try parsing through more than a few pages, you’ll probably get so overwhelmed that you give up. I know I’ve been there.
So which investing basics really matter? I’d argue that not many really do. Sure, you will definitely learn more as you go along, but to begin with, you don’t need much. You need to know a few of the basic valuation metrics, which include terms like price-to-earnings ratio, market cap, price-to-sales ratio, earnings per share, price to earnings growth rate, and so on. There are thousands of resources out there to learn all this stuff, so there’s no use in me reinventing the wheel. Check out this site for a decent overview of these.
The other basic tool you need to have is to be able to read financial statements, or annual reports in general. Annual reports, which are filed by companies when required by the SEC each year, contain a gold mine of information that we as ordinary investors can benefit from. Especially if you aren’t incredibly familiar with a company’s business model, or risk factors, or anything—it’s all in there.
The financial statements (which include the balance sheet, income statement, and cash flow statement) are a section in the annual report that contain all the relevant financial information for that company.
I’m hesitant to recommend it, but the Securities and Exchange Commission put together a decent overview of the basics of reading financial statements. This is a good read if you have time.
The second piece of a strong foundation is always doing your own research. Warren Buffett, the greatest investor of all time, advocates this, and lives it out on a daily basis.
For most of his career (I can’t speak to how he spends his time now), he would spend literally the entire business day reading through annual reports and speaking with CEOs of companies in person or over the phone.
He never would watch CNBC or check through The Motley Fool to find investment opportunities. He did all of his own research. I’d wager that it’s a mindset that we could emulate as well.
Now, granted, most people don’t have the keen business insight to find strong companies that everyone ignores. Obviously, we spend most of our lives online, and that is a very different world than the one Warren Buffett grew up in.
Even still, we have lessons that we can take from it. Doing your own research is one of the best ways to go about investing, and more importantly, it will help you sleep on night. If you buy a stock after hearing Jim Cramer talk about it, you essentially have no idea why that stock might move.
This sets you up for panic and heartbreak when it drops suddenly on some unsuspected news. On the other hand, if you have done all the research on this company, you know all the risk factors, when they are reporting earnings, and other qualitative factors at stake. You will be much more comfortable owning it because you know the potential it has as well as the risks it faces.
In general, doing your own research entails:
Note that sourcing ideas from others isn’t bad—this is actually a great way to find ideas. What is bad is when you don’t bother following through to measure the company yourself. I find plenty of great ideas by following well known hedge fund managers. I hesitate to promote my own material, but I wrote a pretty extensive post on finding investment ideas that you are more than welcome to check out.
The final component to being successful investing is knowing how to manage risk. This is severely under-appreciated in modern investing schools of thought, in my view.
After all, it’s way more fun to spend all your time finding that awesome investment idea and valuing it and building models around it, but we get so caught up in why the idea can go up in value that we forget it can also go down. That’s what managing risk is all about.
A simple way to manage your risk is through what’s called a stop-loss order. Stop-loss orders are given to your brokerage to essentially set a floor below which you are not comfortable owning the stock. If you own Apple (AAPL) right now at around $350-360, and you don’t want to own it if it drops below $300, then you can make that your limit price. Then, when you go on vacation and something terrible happens to the company, your losses will be limited when the stop-loss order executes and closes you out.
Another way to manage risk is to know what your target price is on the upside. Most bank analysts will recommend a stock and provide a “price target.” This is nothing more than the maximum amount they think the company could be worth today (or in the short term).
You could set limit orders to sell if your stock reaches your price target, although this isn’t quite as desirable because then you miss out on the chance for higher gains. However, price targets are useful as a point when you should reevaluate your investment thesis to see if the company is still undervalued.
As a rule for myself, I set reevaluation periods either: 3 months from the purchase date (a simple calendar appointment will do), or when the stock touches my target price, whichever comes first. And of course, if it falls below my lower limit, then my risk is managed there too.
Obviously, this is a very basic overview of investing, but the main takeaway is that it really doesn’t need to be difficult. I work a full time job that has little to do with finance, yet I can still invest successfully without spending a ton of time on it.
To give one example, one stock I bought about six months ago (around September 2010), has since risen close to 60% from when I bought it. The company, Furiex Pharmaceuticals (FURX), has hit a peak in my opinion for the time being, so I closed out of my position to reconsider before I buy back in.
I’m not using this example to brag at all, but I’m simply encouraging you to check out investing if you haven’t yet. It really doesn’t take years of experience to be successful. If you follow a basic set of rules, you dramatically increase your chances of success!
Sunil: A word of caution on the stock market. Achieving great results investing is possible, but I agree with Brett that one must have a good grasp of at least the basics before investing in the market. It doesn’t take long to loose your shirt, and maybe more otherwise . . .Previous: Effective Habits That Have Helped Me Work Less & Get More Done