Thursday, November 8, 2007

Making money in stocks: The only 6 things you need to know

I recently ran across an old issue of Family Money Magazine from 2000 that I saved. It featured an article (the title of this post) on investing in the stock market, and I think the advice is still pretty valid today.

Here are the six principles discussed in the article:

1. Systematic investing can improve your results dramatically. The author says that investing on a regular basis helps you to develop the discipline to stay in the market for the long term. She also mentions dollar cost averaging, which enables you to buy more shares when prices are low, and fewer shares when prices are high, but it's a strategy not without criticisms. I think simply getting started can often be the most challenging step, and systematic (or automatic) investing can lessen the pain because you are buying a little chunk of the market at a time, rather than taking a big bite at once. If you do decide to use the DCA approach and choose to invest in index funds, be aware of the impact that trading fees can have on your investments.

2. How you diversify is the most important determinant of your investment return. Yahoo! Finance featured an article before Halloween about personal finance horror stories, and one of the tales involved an investor who, over the course of four years, lost 98% of an $8 million portfolio that was invested in seven or eight stocks. Clearly diversification is important, and I would add that including international stocks in your investment portfolio is a good diversification strategy as well.

3. No money manager can beat the market over the long run. Neglecting the fact that even pros are unable to consistently predict how the market will move, the author points out that trading costs erode returns by about 0.81% a year, and management expenses further eats into returns. Large company funds have an average expense ratio of 1.23% a year, compared to 0.43% for the average index fund (according to Morningstar, 2000). If you think of money managers as middlemen who take their cut of the profit, and it's easy to understand why they have to outperform the market just to break even. I usually prefer ETFs or index funds to actively managed funds for this reason.

4. Over the years, growth stocks are your best bet. The author says you want to buy companies that are growing consistently and steadily, and that it's harder for investors to predict which value stocks (whose shares are cheap compared to the company's current earnings) are going to take off. I suppose from a risk perspective, it makes sense to buy companies that have proven track records than to gamble on newcomers, although I think owning value stocks can be part of a diversified portfolio.

5. A good stock is a bad investment if it's overpriced. Look at the P/E (price-to-earnings) ratio. If the stock is trading at a high P/E compared to historical values, you may want to wait, according to the author. I think there's more to determining the worth of a company or stock than simply looking at its P/E ratio, but it's certainly one factor to consider.

6. Trying to time the market is futile. Market timing is an investment strategy that never pays off in the long run, because the likelihood that you'll enter and exit at the right time is slim. It's better to buy and hold, which also prevents commissions and taxes from eroding your returns.

If you're a beginner investor, these six simple rules may help you to get started in the right direction.

Karen Cheney
Family Money Magazine
October 2000 issue

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