These tips for picking and investing in stocks are from smart investor and author, Praveen Puri. Here, he describes the difference between foolish gambling and wise investing.
“Investing in stocks is one of the best ways for people to build wealth over the long term – provided that they approach their investments like a business, rather than gambling,” says Puri, who wrote Stock Trading Riches: The Simple, But Powerful Formula That Transforms Your Stock Picks Into Money Pumps.
A bestselling book on picking and investing in stocks is Warren Buffett Invests Like a Girl: And Why You Should, Too. It’s definitely worth a read — learn from the financial gurus!
And, here are Puri’s tips for picking and investing in stocks for smart investors…
The Difference Between Gamblers and Smart Investors
If you look at any casino, you will find two groups of people – gamblers (customers) and business people (owners). During any individual bet, either group can win or lose. Over the long term, however, while the customers have the fun and excitement, only the casino’s owners build long term wealth. This is because the owners have an edge – i.e. the odds are in their favor. While they can win or lose any individual bet, they know that, if they stay in the game, they will make a lot of money over time. As a result, casinos protect their edge by staying disciplined and having table limits – so that they cannot be wiped out by a customer on a lucky streak.
In the same way, investors in the stock market have no control over short term movements in the market. However, if they can give themselves an edge (by systematically buying low and selling high) and can avoid getting wiped out by a few companies that go out of business, they can create financial wealth.
Most investors however, do not nurture this edge. The two biggest mistakes they make are buying / selling out of fear and greed, and not having rules for how much they should invest in any particular stock.
For example, a typical investor might get a hot tip from a friend to buy stock ABC. Their friend tells them that the stock has already started climbing and the “skies the limit”! The investor then decides to buy $1,000 worth of the stock because that is the amount of money they have on hand. Let’s say that the investor then buys the stock at $10. One of two things could happen. The stock drops to $9, and the investor panics and sells. Or, the stock climbs to $11 and the investor feels successful and sells, because he does not want to lose the profit. Two weeks later, the stock is trading at $15.
The above scenario is what a gambler would do.
Now, we will look at a smart, business-minded investor who also got a hot tip for stock ABC. First, the investor reads about the company. He finds out what the company does and if the business seems like something that will make money over the long term. He then reads analyst recommendations at sites like Yahoo Finance, or in magazines like Forbes. If the analysts feel it is a good company that will be around and thrive, and they think the stock is currently trading at a good price, then the investor decides to buy the stock.
Before an investor buys, he will know how much he wants to initially invest in the company, at what prices he will sell, and at what prices, if any, he will add to his position.
It’s having this systematic approach, rather than great stock picking, that insures an investor’s success. In fact, most people would be surprised to learn that success in the stock market is NOT a result of picking blockbuster stocks like Microsoft in the early 1980’s or Google in 2000. Instead, the most important cause of great returns are asset allocation – building large stock positions when stocks are down, and selling down to smaller stock positions when the market is overvalued.
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5 Tips For Picking and Investing in Stocks for Smart Investors
1. Avoid speculative stocks that are not currently making money. Read sources like Yahoo Finance, MSN Finance, and Forbes Magazine. Choose recommended stocks in which you understand the business, and the reason for the recommendation makes sense to you. For example, I bought Canadian National Railroad (an easy to understand business) when it was recommended because they have exclusive rail access to a new shipping port in Vancouver that is a day closer to Shanghai than Long Beach. The stock did very well.
2. Don’t buy stocks that are cheap compared to their all time highs, unless analysts feel that their fundamental business is still ok. One of my biggest losers was Nortel. I bought it because it was cheap, bought more as it went down – and then got out just before it went bankrupt.
3. Decide on allocations. For example, maybe 20% of your account will be in cash, and each stock position will be no more than 2% of your portfolio value. Because the Nortel position was a small part of my portfolio, it did not cause a serious loss.
4. Don’t make binary (all-or-nothing) buys and sells. For example, if a stock rises, think about selling a portion of your holdings, so you still have some shares in case the stock continues to climb. If the stock price drops, but there are no fundamental problems with the company, then consider investing some more money into the stock.
5. Don’t dwell on your mistakes. After I decided that I should sell Nortel, I did not focus on my financial loss. Instead, I focused on finding another stock to replace the position with.
And, if you need help with investing your money, read Tips for Choosing a Financial Planner.
You may also be interested in learning about Tips for Borrowing Money to Invest.
Do you have any questions or tips for investing in certain stocks? You’re welcome to comment below!
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Praveen Puri is a Chicago-based business and finance blogger who is passionate about simplicity and minimalism. He’s been a full time trader, software developer, consultant, and vice president of a major bank.