It doesn’t take a Ph.d. or years of research to realize that stocks, in the long run, can offer investors superior returns when compared to fixed-income investments. So, are you ready to dive in? Good. Before we do, however, let’s take a minute to think about our overall strategy first. Personally, I have learned the hard way that planning is the most important step in the investing process. I find it’s extremely important to realistically understand your personal risk profile, time horizon, personal finances, and the amount of time you have available for research before you act.
Your Risk Profile
Tolerance for risk is an extremely important factor to consider when choosing an investment strategy. This is because the decisions we make are affected by our perception of risk. Ask yourself one thing: if you invest in the stock market will you lose sleep when the market goes down? That is, will volatile stock prices stress you out? Will you be compelled to sell everything at the first opportunity in order to make sure you don’t lose money? If the answer is “yes”, then like many people you have a lower tolerance for risk.
Don’t worry, this is a good thing, and generally leads people to make smart decisions when it comes to personal finances (i.e., carrying very little debt, etc.). However, no amount of money is worth peace of mind, and you should consider a more conservative mix of stocks and bonds that are less volatile. Doing so will also help you avoid suboptimal decisions (such as the tendency to buy when the market is sky high and sell when it is down).
Time Horizon
Your personal time horizon is also extremely important as well. Are you about to retire soon? If so, you should focus on capital preservation by investing in low risk, low volatility stocks and bonds. This will provide you with a return while ensuring you have adequate funds for your golden years.
Personal Finances
Are you living paycheck to paycheck? Do you carry large amounts of debt or high interest debt? You should get this situation under control before you start investing. Credit cards can charge ridiculously high interest rates (25% or more!) and, after inflation, even if you outperform the market investing you lose money. Further, the interest on credit cards is typically compounded daily. What does that mean? That means that even if your APR is 25%, you are actually paying more because the interest is compounded more frequently! That’s one of the sneaky business tricks most folks tend to forget about.
Making Time
That amount of time you have to devote to investing is also very important. For the most part, the average investor can be successful by simply investing in broad market indices such as the S&P 500, as well as some form of bonds (for risk diversification). This can be done through Exchange Traded Funds (ETFs) or mutual funds. However, as John Bogle has argued continuously, index funds that charge minimal fees offer much better returns than actively managed mutual funds (by the way, John Bogle founded a “little” company by the name of the Vanguard Group). If you haven’t already, I highly recommend you read his latest book: The Little Book of Common Sense Investing
Investing in Stocks
If you are willing to do the research and invest the time, it is possible to beat the market by investing in a portfolio of individual stocks. Want proof? How about Warren Buffett. The CEO of Berkshire Hathaway, Buffett is probably the most successful value investor of our time. He is extremely good at finding companies with stock that has been underpriced or neglected by Wall Street, then buying that stock at rock bottom prices.
Buffett’s portfolio consists of companies such as Fruit of the Loom, International Dairy Queen, Inc. and Jordan’s Furniture. Sound boring? Exactly! At one point or another Wall Street forgot about these companies and went off chasing the next big thing. Meanwhile, Buffett took a good look at the numbers, decided the stock was worth more than its trading price, then waited until it fell even lower before buying in. Even Buffett admits you don’t have to be a rocket scientist to make this work, all you need is discipline and a keen eye.
Related Links: Value Stocks, Growth Stocks, Dividend Stocks