While the stock market is riddled with uncertainty, certain tried-and-true principles can help investors boost their chances for long-term success. Here are 10 fundamental concepts every investor should know:
Some investors lock in profits by selling their appreciated investments, while holding onto underperforming stocks they hope will rebound. But good stocks can to climb further, and poor stocks risk zeroing out completely. The following information can help navigate these decisions:
Riding a Winner
Peter Lynch famously spoke about "tenbaggers"-investments that increased tenfold in value. He attributed his success to a small number of these stocks in his portfolio. But this required the discipline of hanging onto stocks even after they’ve increased by many multiples, if he thought there was still significant upside potential. The takeaway: avoid clinging to arbitrary rules, and consider a stock on its own merits.
Selling a Loser
- There is no guarantee that a stock will rebound after a protracted decline, and it’s important to be realistic about the prospect of poorly-performing investments. And even though acknowledging losing stocks can psychologically signal failure, there is no shame recognizing mistakes and selling off investments to stem further loss.
In both scenarios, it’s critical to judge companies on their merits, to determine whether a price justifies future potential.
Don't Chase a Hot Tip
Regardless of the source, never accept a stock tip as valid. Always do your own analysis on a company, before investing your hard-earned money. While tips sometimes pan out, long-term success demands deep-dive research.
Don't Sweat the Small Stuff
Rather than panic over an investment’s short-term movements, it’s better to track it’s big-picture trajectory. Have confidence in an investment’s larger story, and don’t be swayed by short-term volatility.
Don't overemphasize the few cents difference you might save from using a limit versus market order. Sure, active traders use minute-to-minute fluctuations to lock in gains. But long-term investors succeed based on periods of time lasting years or more.
Don't Overemphasize the P/E Ratio
Investors often place great importance on price-earnings ratios, but placing too much emphasis on a single metric is ill-advised. P/E ratios are best used in conjunction with other analytical processes. Therefore 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.
Resist the Lure of Penny Stocks
Some mistakenly believe there’s less to lose with low-priced stocks. But whether a $5 stock plunges to $0, or a $75 stock does the same, you've lost 100% of your initial investment, therefore both stocks carry similar downside risk. In fact, penny stocks are likely riskier than higher-priced stocks, because they tend to be less regulated.
Pick a Strategy and Stick With It
There are many ways to pick stocks, and it’s important to stick with a single philosophy. Vacillating between different approaches effectively makes you a market timer, which is dangerous territory. Consider how noted investor Warren Buffett stuck to his value-oriented strategy, and steered clear of the dotcom boom of the late '90s—consequently avoiding major losses when tech startups crashed.
Focus on the Future
Investing requires making informed decisions based on things that have yet to happen. Past data can indicate things to come, but it’s never guaranteed.
In this 1990 book "One Up on Wall Street". Peter Lynch stated: "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." It’s important to invest based on future potential versus past performance
Adopt a Long-Term Perspective
While large short-term profits can often entice market neophytes, long-term investing is essential to greater success. And while active trading short-term trading can make money, this involves greater risk than buy-and-hold strategies.
Many great companies are household names, but many good investments lack brand awareness. Furthermore, thousands of smaller companies have the potential to become the blue-chip names of tomorrow. In fact, small-caps stocks have historically shown greater returns than their large-cap counterparts. From 1926 to 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. But there are many great companies beyond those in the Dow Jones Industrial Average (DJIA).
Be Concerned About Taxes, but Don't Worry
Putting taxes above all else can cause investors to make misguided decisions. While tax implications are important, they are secondary to investing and securely growing your money. While you should strive to minimize tax liability, achieving high returns is the primary goal.