Editor’s note: This article was first published in December 2014; the Abengoa example, in which the author says he underestimated the company’s high debt, reflects the situation then. Abengoa entered pre-insolvency proceedings in late 2015 and went through restructurings afterwards.
Investing in the stock market isn’t that complicated, but it isn’t that simple either. It’s not as hard as some people think, but it’s not as easy as others try to sell it to you. At times, the people who know the most even end up with lower returns than the people who know the least and invest on the simplest basis.
Still, there are some tips that apply across the board and that you should always keep in mind when you venture into the exciting world of stock market investing.
(Read: 19 investing secrets everyone should know before investing)
These are 11 simple tips and guidelines to follow when investing in the stock market
1. Do your own research on the company you’re going to invest in
This is probably the part most people forget, either because they have trouble understanding a company’s balance sheet or out of laziness. As incredible as it sounds, many people invest in a company without knowing exactly what it does. They invest only because an analyst, expert or millionaire said that company X could deliver high returns.
(Read: Show me the money: lessons from Enron and Gowex that every investor should learn)
As part of that research, the following points come in.
2. Look at the long term
We’re not talking here about investing for the long term, but about looking at the company’s performance on a long-term chart. In other words, don’t look only at the share price over the last 5 years. If possible, look at the chart for the last 20 or 30 years, if the company has been around that long.
That chart holds valuable information. A company may be in an uptrend on a short-term chart while its main long-term trend is completely bearish. In the same way, you’ll also be able to see how the company behaved in previous crises. An investor feels much calmer seeing that the company they’re investing in came through earlier crises with less damage to its share price than other companies, and even better than the index itself.
3. What’s the next big thing?
Is it renewables, electric cars, social networks…? Clearly an investor should ask what the next business of the century will be, the next growth industry, but be very careful about falling for fashionable companies, which may be very good for speculating in the short to medium term but terrible for serious long-term investing. But once you get to this point…
4. …Avoid overvalued companies
A company may have been very profitable, have an excellent business and have risen 1,000% in the last year. The company may be the best thing ever, but… has the market already priced in all those expectations? Sometimes buying hot stocks means we’re buying a company that’s very fashionable among investors, but buying it at a truly expensive price.
5. Sometimes the best isn’t always the best
In the stock market, as we’ve said before, you can buy junk and make more money than if you buy Coca-Cola. It depends on the price you paid for the junk and the price you paid for Coca-Cola. It also depends on your investment horizon, because in the stock market…
(See: It’s not what you buy; it’s what you pay for what you buy)
6. …Timing your entry is everything
“As in business, in the stock market you make more money buying than selling.”
If a company has kept rising after 10 years of gains, trading at an astronomical P/E ratio with limited growth expectations for the next year, the only thing that can happen is that you invest just in time to watch the fall begin. At the other extreme, we might have a company that investors have punished excessively, where we could find a buying opportunity. Likewise, investing at a troubled time in the market gives us…
7. …The margin of safety
For me, one of the most important things is finding that margin of safety the value investing books talk so much about. When you buy a stock during steep falls and the share price then starts to recover, once the stock has risen 20, 30 or 1,000%, you can rest easy knowing you’ll have a precious amount of time to react if the company starts to fall.
See also: Peter Lynch’s principles: beating Wall Street
The opposite is getting in at a neutral moment and not knowing what to do when your investment starts losing money: do we sell, average down or hold? The margin of safety ensures that, barring force majeure, you’re no longer going to lose money, because you can set stop-losses to exit the market with big gains.
8. Don’t underestimate companies’ debt
Return lies in risk. And precisely during a market recovery you can make big money betting on speculative small caps instead of blue chips. But many of these small caps, and sometimes not-so-small ones, have so much debt that it puts their whole business at risk.
The example of Abengoa: I like Abengoa’s business, but I personally underestimated the company’s high debt, and as we can see, the market hasn’t forgiven it. Had it not been for the margin of safety, there would have been no way to avoid taking the big losses the company has piled up.
See also: What’s a reasonable average annual return from the stock market?
9. Understand the whole stock market business
There are still many people who think the stock market is only about investing in a company, waiting for it to rise and selling; they forget about dividends. Since we talk so much about building assets that generate passive income, stocks can achieve that: we choose a solid company that pays dividends, and make sure those dividends are consistent over time.
Investing with this mindset, falls in the share price are blessings for an investor who doesn’t want to take risks and can carry out a dollar-cost averaging (DCA) strategy. And if, on top of that, you’re lucky enough that those solid companies do better than the rest while taking on less risk, congratulations. (See: In the end, the most profitable stocks were the ones we recommended to conservative investors.)
See also: Is it time to invest in the stock market? A market analysis
10. How you behave when you get it wrong
It’s very common for someone to talk about “trying their luck” in the stock market, make their investment, get in at the worst moment in the market, take a big fall while waiting for their investment to recover and, when that doesn’t happen, decide to sell at a hefty loss.
I know of people who started out in the stock market by cutting losses of 7,000 and 9,000 euros. And since the stock market is, in the end, more emotional than anything else, these people act like jilted lovers who never want to hear about the stock market again, missing the chance to get back in and take advantage of the rises that usually follow big falls.
11. When the time comes, remember you can use both directions of the market
As we’ve explained before, today it’s easy for any investor to go long or short in the markets. In other words, you can make money whether the market goes up or down. And when one-off conflicts hit the markets, a bearish bet can make you as much money as a bullish investment. But that’s pure, hard speculation.
(See: Tips for making money in a bear market)
But above all, you need to keep in mind what you are, because many people claim to be long-term investors when they’re really short-term speculators who hold for the long term only if the investment goes wrong in the short term.
Further reading
- How Warren Buffett analyzes companies before investing in them
- Warren Buffett’s 16 best investing tips
- 10 investing lessons from Jim Rogers
- Probably the mother of all stock market investing mistakes
Featured image: CarlosVdeHabsburgo, CC BY-SA 4.0, via Wikimedia Commons.
