While it may be true that in the stock market there is no rule without an exception, there are some principles that are tough to dispute. Let's review 10 general principles to help investors get a better grasp of how to approach the market from a long-term view. Every point embodies some fundamental concept every investor should know.
1. Sell the losers and let the winners ride!
Time and time again, investors take profits by selling their appreciated investments, but they hold onto stocks that have declined in the hope of a rebound. If an investor doesn't know when it's time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice. The following information might help:
- Riding a Winner - Peter Lynch was famous for talking about "tenbaggers", or investments that increased tenfold in value. The theory is that much of his overall success was due to a small number of stocks in his portfolio that returned big. If you have a personal policy to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a "sell-after-I-have-tripled-my-money" mentality has ever had a tenbagger. Don't underestimate a stock that is performing well by sticking to some rigid personal rule - if you don't have a good understanding of the potential of your investments, your personal rules may end up being arbitrary and too limiting. (For more insight, see Pick Stocks Like Peter Lynch.)
- Selling a Loser - There is no guarantee that a stock will bounce back after a protracted decline. While it's important not to underestimate good stocks, it's equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because it's also an acknowledgment of your mistake. But it's important to be honest when you realize that a stock is not performing as well as you expected it to. Don't be afraid to swallow your pride and move on before your losses become even greater.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses. (For related reading, check out To Sell Or Not To Sell.)
2. Don't chase a "hot tip".
Whether the tip comes from your brother, your cousin, your neighbor or even your broker, you shouldn't accept it as law. When you make an investment, it's important you know the reasons for doing so; do your own research and analysis of any company before you even consider investing your hard-earned money. Relying on a tidbit of information from someone else is not only an attempt at taking the easy way out, it's also a type of gambling. Sure, with some luck, tips sometimes pan out. But they will never make you an informed investor, which is what you need to be to be successful in the long run. (Find what you should pay attention to - and what you should ignore in Listen To The Markets, Not Its Pundits.)
3. Don't sweat the small stuff.
As a long-term investor, you shouldn't panic when your investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitable volatility of the short term. Also, don't overemphasize the few cents difference you might save from using a limit versus market order.
Granted, active traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself. (Learn the difference between passive investing and apathy in Ostrich Approach To Investing A Bird-Brained Idea.)
4. Don't overemphasize the P/E ratio.
Investors often place too much importance on the price-earnings ratio (P/E ratio). Because it is one key tool among many, using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesn't necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued. (For further reading, see our tutorial Understanding the P/E Ratio.)
5. Resist the lure of penny stocks.
A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a $5 stock that plunges to $0 or a $75 stock that does the same, either way you've lost 100% of your initial investment. A lousy $5 company has just as much downside risk as a lousy $75 company. In fact, a penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it. (For further reading, see The Lowdown on Penny Stocks.)
6. Pick a strategy and stick with it.
Different people use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick with it. An investor who flounders between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely territory most investors should avoid. Take Warren Buffett's actions during the dotcom boom of the late '90s as an example. Buffett's value-oriented strategy had worked for him for decades, and - despite criticism from the media - it prevented him from getting sucked into tech startups that had no earnings and eventually crashed. (Want to adopt the Oracle of Omaha's investing style? See Think Like Warren Buffett.)
7. Focus on the future.
The tough part about investing is that we are trying to make informed decisions based on things that have yet to happen. It's important to keep in mind that even though we use past data as an indication of things to come, it's what happens in the future that matters most.
A quote from Peter Lynch's book "One Up on Wall Street" (1990) about his experience with Subaru demonstrates this: "If I'd bothered to ask myself, 'How can this stock go any higher?' I would have never bought Subaru after it already went up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that." The point is to base a decision on future potential rather than on what has already happened in the past. (For more insight, see The Value Investor's Handbook.)
8. Adopt a long-term perspective.
Large short-term profits can often entice those who are new to the market. But adopting a long-term horizon and dismissing the "get in, get out and make a killing" mentality is a must for any investor. This doesn't mean that it's impossible to make money by actively trading in the short term. But, as we already mentioned, investing and trading are very different ways of making gains from the market. Trading involves very different risks that buy-and-hold investors don't experience. As such, active trading requires certain specialized skills.
Neither investing style is necessarily better than the other - both have their pros and cons. But active trading can be wrong for someone without the appropriate time, financial resources, education and desire. (For further reading, see Defining Active Trading.)
9. Be open-minded.
Many great companies are household names, but many good investments are not household names. Thousands of smaller companies have the potential to turn into the large blue chips of tomorrow. In fact, historically, small-caps have had greater returns than large-caps; over the decades from 1926-2001, small-cap stocks in the U.S. returned an average of 12.27% while the Standard & Poor's 500 Index (S&P 500) returned 10.53%.
This is not to suggest that you should devote your entire portfolio to small-cap stocks. Rather, understand that there are many great companies beyond those in the Dow Jones Industrial Average (DJIA), and that by neglecting all these lesser-known companies, you could also be neglecting some of the biggest gains. (For more on investing in small caps, see Small Caps Boast Big Advantages.)
10. Be concerned about taxes, but don't worry.
Putting taxes above all else is a dangerous strategy, as it can often cause investors to make poor, misguided decisions. Yes, tax implications are important, but they are a secondary concern. The primary goals in investing are to grow and secure your money. You should always attempt to minimize the amount of tax you pay and maximize your after-tax return, but the situations are rare where you'll want to put tax considerations above all else when making an investment decision (see Basic Investment Objectives).
There are exceptions to every rule, but we hope that these solid tips for long-term investors and the common-sense principles we've discussed benefit you overall and provide some insight into how you should think about investing.