Successful investors develop their skills over decades—sometimes a lifetime—of practice. But there are some basic tricks of the trade that can give you a solid foundation for your investing career.
With any investment, there is always risk involved, and the chance of loss is real. But these investing tips will help you manage your money while reducing different types of risk.
Investing Tip #1: Focus on Cost, But Don't Overdo It
The safest way to try and grab an extra few percentage points of return on your investments is through cost control. But, while you should keep a close eye on your portfolio costs, you need to look at the complete picture.
If you are enrolled in a dividend reinvestment program (DRIP) that charges $2 for each investment and you are putting away $50 per month, your costs are immediately eating 4% of your principal. That's significant, but it can make sense in certain circumstances.
On a high-performing stock, that single, upfront expense each time you purchase shares would be insignificant compared to the expense ratio on some other funds that charge ongoing fees.
The problem is that many investors don't know which expenses are reasonable and which expenses should be avoided. If you're earning $50,000 a year and managing a very small portfolio, it may make the most sense for you to avoid hiring an investment advisor altogether and simply opt for a handful of well-selected, low-cost index funds.
But a wealthy investor with a large portfolio might be better off working with an advisor and purchasing stocks directly, effectively creating their own version of the index fund at a much lower expense ratio.
Knowing which fees are worth it and which ones are rip-offs requires experience.
For example, if the effective fee on a $500,000 managed trust fund is 1.57% all-inclusive, you're getting a fantastic bargain, even if the account isn't as tax efficient as some others. It would be a fool's errand to try and reduce that fee further.
On the other hand, paying a 1.57% expense ratio for an actively managed mutual fund that is largely holding the same stocks as the Dow Jones Industrial Average would be a significant waste of money.
Investing Tip #2: Pay Attention to Taxes and Inflation
When it comes to evaluating your investments, focus your energy on purchasing power. Too many professional portfolio managers either ignore the rate of inflation or focus on pre-tax returns over after-tax returns.
You may earn 9% to 12% over long periods of time, but if you're in a high marginal tax bracket, you will end up with less wealth than you otherwise would have if you had made 10% on investments structured with tax day in mind.
Why? In addition to the enormous cost savings that result from long-term investing (as opposed to short-term trading), there are several tax advantages. Here are some of them:
- Short-term capital gains are taxed at personal income tax rates. These can be much higher than long-term capital gains rates. In 2020, the highest federal marginal income tax rate was $37%. The highest rate on most long-term capital gains, however, is only 20%.
- Unrealized gains allow you to continue compounding your returns. When you sell an investment to buy another, you are will have to pay commissions and taxes, leaving you substantially less to reinvest. For it to be worth it for you to move investments like this, your new position has to be significantly better than your old one. Otherwise, it's better to save on commissions and taxes.
- Where and how you hold your investments can impact your ultimate compounding rate. If you own shares of many different companies, some of these stocks are likely to pay large cash dividends, while others retain most profits to fund future expansion. Certain types of bonds, such as tax-free municipal bonds, can be exempt from taxes even when held in taxable accounts under the right conditions, while taxes on the interest on some corporate bonds can add up to almost 50%.
- Your employer-matched 401(k) represents one of the best ROIs you can get. If your employer matches $1 for $1 on the first 3%, for example, you are instantly earning a 100% return on your money.
Investing Tip #3: Know When to Sell a Stock
You already know that frictional expenses can make buying and selling stock in rapid-trading fashion seriously lower your returns. Still, there are times when you may want to part with one of your stock positions.
How do you know when it’s time to say goodbye to a favorite stock? The following are some key signs:
- Earnings were not properly stated.
- Debt is growing too rapidly.
- New competition is likely to seriously harm the firm’s profitability or competitive position in the marketplace.
- Management’s ethics are questionable.
- The industry as a whole is doomed due to a commoditization of the product line.
- The market price of the stock has risen far faster than the underlying diluted earnings per share. Over time, this situation is not sustainable.
- You need the money in the near future—a few years or less. Although stocks are a marvelous long-term investment, short-term volatility can cause you to sell out an inopportune moment, locking in losses. Instead, park your cash in a safe investment such as a bank account or a money market fund.
- You don’t understand the business, what it does, or how it makes money.
History has shown that it is generally not a good idea to sell because of your expectations for macroeconomic conditions, such as the national unemployment rate or the government’s budget deficit, or because you expect the stock market to decline in the short term. Analyzing businesses and calculating their intrinsic value is relatively simple. You have no chance of accurately and consistently predicting the behavior of millions of other investors.
Investing Tip #4: You Don't Need an Opinion on Every Investment
The major brokerage firms, asset management groups, and commercial banks seem to feel like it is necessary to attach a rating to every security that is traded. Some popular financial talk show hosts take pride in espousing their view on virtually every business on the market.
While this can be useful when looking at corporate bonds and discovering whether they trade more toward the AAA rating or junk bond side of the spectrum, in a lot of cases, this obsession with metrics is somewhat nonsensical.
Investing is not an exact science. If you focus on only acting where there is a clear winner and watching for opportunities that come along every once in a while, you are likely to do better than the Wall Street analysts that stay up nights trying to decide if Union Pacific is worth $50 or $52.
Instead, you wait till the stock is trading at $28, then pounce. When you do find an excellent business, you are often best served by near-total passivity and holding until death. This approach has minted a lot of secret millionaires.
Why do investors find it so hard to admit that they don't have a clear-cut opinion about a specific business at the current market price? Often, pride and, to some degree mental discomfort over the unknown, are the culprits.
Investing Tip #5: Know Every Company (Or a Lot of Them)
Even if you don't have an opinion on the specific attractiveness of most stocks at any given moment, you should know as many businesses across as many sectors and industries as you can.
This means being familiar with things like return on equity and return on assets. It means understanding why two businesses that appear similar on the surface can have very different underlying economic engines.
When asked what advice he would give a young investor trying to enter the business today, Warren Buffett said that he would systematically get to know as many businesses as he could because that bank of knowledge would serve as a tremendous asset and competitive advantage.
For example, when something happened that you thought would increase the profits of copper companies, if you knew the industry ahead of time, you'd be able to act much more quickly and decisively than if you had limited knowledge.
It may sound overwhelming to start learning about the countless businesses and industries represented on the stock market. Try starting with the roughly 1,700 companies in the Value Line Investment Survey, which offers a monthly newsletter detailing some of the challenges facing various companies or industries.
Investing Tip #6: Remember Return on Inventories
Many investors only focus on the DuPont model return on equity that a firm generates. This is a very important figure.
In fact, if you only had to focus on a single metric that would give you a better-than-average chance of getting rich from your stock investments, you should aim for a collection of companies with sustainably high returns on equity.
However, there is a better test of a company's true economic characteristics, especially when used in conjunction with owner earnings: return on inventories. More specifically, you can use what's called the gross margin return on inventory (GMROI), a metric that illustrates how much a company earns for every dollar spent.
Whereas other financial ratios and metrics can be dressed up for an initial public offering or by a company's management, this test is much harder to fake.
To find a company's GMROI, divide gross margin (income minus cost of goods) by the average inventory cost on the balance sheet. A number below one means a company is losing money by doing business.
Anything higher than one is a sign of a profitable operation. The higher, the better, of course, but averages vary by industry.
Investing Tip #7: Look for Shareholder-Friendly Management
In general, investors are likely to get much better results from managers who have their own capital tied up in the business alongside the outside minority investors. While it cannot guarantee success, it does go a long way toward aligning interests.
Companies such as U.S. Bancorp require executives to keep a certain multiple of their base salary invested in the common stock.
Likewise, management's affirmation that a portion of capital will be returned to the owners each year in the form of cash dividends and share repurchases and their constant ability to maintain one of the best efficiency ratios in the industry shows that they really do understand that they work for the stockholders.
Investing Tip #8: Stick to Stocks You Know
In investing, as in life, success is just as much about avoiding mistakes as it is about making intelligent decisions. If you are a scientist who works at Pfizer, you are going to have a very strong competitive advantage in determining the relative attractiveness of pharmaceutical stocks compared to someone who works in the oil sector.
Likewise, a person in the oil sector is probably going to have a much bigger advantage over you in understanding the oil majors.
Peter Lynch was a big proponent of the “invest in what you know” philosophy. In fact, many of his most successful investments were a result of following his wife and teenage kids around the shopping mall or driving through town eating Dunkin’ Doughnuts.
Just because you worked the counter at Chicken Mary's as a teenager doesn't mean you know how to analyze a poultry company such as Tyson Chicken. Ask yourself if you know enough about a given industry to take over a business in that field and be successful. If the answer is "yes," you may have found your niche. If not, keep studying.
Investing Tip #9: Diversify
Warren Buffet said that "diversification is insurance against ignorance." What he actually meant was that it's better to invest in a few stocks you know well.
But, where there are holes in your knowledge, diversification helps you hedge your bets.
These days, widespread diversification can be had at a fraction of the cost of what was possible even a few decades ago. With index funds, mutual funds, and dividend reinvestment programs, the frictional expenses of owning shares in hundreds of different companies have largely been eliminated or substantially reduced.
This can help protect you against permanent loss by spreading your assets out over enough companies that if one or even a few of them go belly-up, you won’t be harmed.
To diversify effectively, watch for correlation. Specifically, you want to look for uncorrelated risks so that your holdings are constantly offsetting each other to even out economic and business cycles. Don't invest all your stocks in companies within the same industry, or even in different industries affected by the same economic factors.
Investing Tip #10: Know Financial History
It has been said that a bull market is like love. When you're in it, you don’t think there has ever been anything like it before.
Billionaire Bill Gross, considered by most on the street to be the best bond investor in the world, has said that if he could only have one textbook out of which to teach new investors, it would be a financial history book, not accounting or management theory.
Think back to the South Sea Bubble, the Roaring Twenties, Computers in the 1960s, and the internet in the 1990s. If more investors knew the factors that shaped these events, it is doubtful that so many would have lost substantial portions of their net worth in the dot-com meltdown or the real estate collapse.
Investing Tip #11: Reinvest Your Dividends
Unless you need passive income from your dividends, reinvesting them is one of the best ways to dramatically increase the size of your portfolio.
For example, imagine a company's share price triples over 10 years. You bought 1,000 shares at the beginning.
If you cashed out your dividends along the way, you'd still have 1,000 shares 10 years later, now worth three times as much. But you could have used those dividends to buy more shares, which would have multiplied your earnings throughout the life of your investment.
Investing Tip #12: Don't Pay More Than a Company Is Worth
Although Charlie Munger's dictum, "a good business at a fair price is superior to a fair business a great price" is true, it is important for you to realize that good results aren't likely if you buy such stocks regardless of price.
It's a fine distinction, but one that can mean the difference between good results and disastrous losses.
Back in the late 1960s, Wall Street became enthralled with a group of stocks dubbed the "Nifty Fifty." On the surface, these stocks looked like big winners.
They had recognizable brand names and strong profits. They included everything from American Express and Coca-Cola to Gilette and Xerox.
The problem was that investors believed so strongly in these companies that there were willing to buy them at any price. More often than not, however, a stock trading at a price-to-earnings ratio of 60-times or more is almost assuredly going to generate a rate of return less than that of a so-called "risk-free" U.S. Treasury bond.
For 20 to 30 years after the Nifty Fifty peaked, the basket of stocks, as a whole, underperformed the market before eventually excelling in the long-range.
When dealing with excellent businesses, the ghost ship approach, historically, has won in the long-run but how many investors are willing to stick with 30 or 40 years of near-total passivity?
All things being equal, it's best to avoid investments that are priced to perfection with no margin of safety. Otherwise, a mere blip in operating performance could cause a long-term, catastrophic loss in principal as fickle speculators flee to hotter securities.
If you are going to consider investing in high-priced stocks, it may be best to stick to the bluest of the blue chips. You can probably get away with overpaying for a company like Johnson & Johnson if you're going to hold it for the next 50 years, but a company such as Facebook is a bigger question mark.
Investing Tip #13: Go for Funds That Encourage Passivity
Index funds are a great option for smaller investors without a lot of money or in lower tax brackets.
Despite the structural risks inherent in them and the methodology changes that have cost investors a lot of money, they allow individuals and families with little to no capital to achieve widespread diversification at almost no cost.
However, index funds are not perfect. In some ways, they don't seek the efficient allocation of capital to productive ends but, rather, piggyback off the activity of others.
In theory, they should work great as an investment vehicle as long as too many people don't rely on them. On the other hand, if the current trends continue and indexing takes larger and larger shares of the total asset pool, there could come a day when the money flows into index funds could create a significant disconnect between the intrinsic value of the firms held in the index and the market prices of those firms.
Nevertheless, if you aren't affluent or rich, indexing is probably your best bet for simple, straightforward, mostly passive investments. Just be aware of the risks in what you are doing and know that there are dangers even when everyone says index funds are fool-proof.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.