The stock market may seem intimidating and complex, and it can be, but the basic ideas behind successful stock investments are very simple. Equity investing can be summed up in the old adage, buy low and sell high.
However, doing this successfully requires research, patience, and discipline. Many of the most basic concepts of successful stock investing require a good deal of mental discipline. Let’s explore the conventional wisdom in stock investing and why many fail to follow it.
Time in the market is more important than timing the market when it comes to long-term stock investing. In other words, there is more money to be made in holding an investment for a long time than buying and selling the same investment in a short period of time.
Albert Einstein is quoted as saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
The concept of compound interest or compound gains is reinvesting your profits at regular intervals. This means that each investment you make is larger than the last, and each return is proportionally larger. This allows for exponential returns in your investments.
If you make 10% in an average year in the stock market, that return can be reinvested for another 10%, and overall you will have made 21%. After 10 years, that annual compounding will return 159%. After 20 years, you will have made 672% of your initial investment.
You can see how patience pays off, and how compounding can work in your favor. Time in the market always beats timing the market, especially if your investments involve timing the market repeatedly over a long period of time.
Stock market investing often goes against the most natural human impulses. Most importantly, the impulses of fear and greed will work to reduce your gains and increase your losses. Being able to set aside these emotions and invest with a cool head will yield great returns.
This means trusting your analysis, going against general sentiment in the market, and allowing your profits to grow when they can easily be cashed out for a quick profit.
Legendary investor Warren Buffet is known as the king of value investing. This is a long-term investing approach that involves looking at the facts and fundamentals of the companies you invest in.
Market news and popular trends may come and go, but the fundamentals will always speak to the underlying value of a stock. Fortunately, the internet has made the old school detective work behind researching fundamentals a lot easier. Here are some important fundamental metrics.
Also known as the profitability ratio, the ROE is the total amount of profit a company makes after separating out shareholder equity. If a company has a positive ROE that grows each year, it’s a sign of a healthy stock worth investing in. This is likely the most important fundamental to consider when investing, as it is the actual amount of money a company makes each year.
This ratio is simply the price of the current stock price divided by the annual earnings per share or EPS. This ratio will tell if a stock is overvalued or undervalued. If a stock is undervalued, then it is a good buy. If it’s overvalued it’s worth avoiding or selling.
This metric is simply how much cash is flowing into the company after expenses are paid. Accounting standards don’t include floating cash when it comes to things like ROE or PE Ratio, so Free Cash Flow is a great metric to judge the health of a company’s stock. A company with high positive FCF has the future potential for growth and stock gains.
While these metrics were once advanced and reserved for investors with the means to access and calculate them, the internet has made it easy for anyone to check fundamental metrics and more online. Simply search for the company along with the fundamental terms.
We talked about fear and greed earlier, but how does this affect stock price?
When prices drop and large sell-offs occur, the general sentiment in the market is fear. Fear of buying and fear of taking further losses for those who own stock. This fear continues after a major drop or market crash has ended and turned around.
Buying stock after large price drops can be very profitable. This is because the stock is at a low price and will return to an equilibrium after the major movement has passed. Buying against fear is a great demonstration of how following general sentiment can lead to loss.
When your investment makes a profit, you want to collect all the profit that the market can give you. The sentiment of greed will make many investors sell off their shares and collect profit as soon as they possibly can. This greatly reduces the profit potential of your investment.
An old adage on Wall Street is cut your losses early and let your profits run. In other words, be quick to let go of bad investments and accept that sometimes you make mistakes. On the other side, hold on to good investments until it’s clear the movement has run its course.
Finally, if you must sell stock in a company that is doing well in the long-term, consider using your profits to strategically buy more shares and compound your gains. You can also simply sell a small portion of your shares and purchase more with the resulting profits.
Buying individual stocks can be risky. While larger blue chip companies offer large gains with lower risk, many less expensive stocks can have rapid price swings. When investing in the stock market, it’s important to diversify.
In other words, you want to spread your money across several different investments. This way your portfolio stays balanced if one of your investments does poorly, and you benefit from different assets and industries.
An easy way to diversify is equity funds. These are funds managed by investment professionals that are already strategically invested across several companies and assets. Buying a share in an equity fund means benefitting from several professionally managed investments without having to do the legwork yourself.