The Savvy Investor’s Guide to Building Wealth with Traditional Investments

2.1. WHAT DO THE FOLLOWING TERMS MEAN – SAVING, INVESTING, GAMBLING, TRADING, AND SPECULATING?

Financial terms can be confusing. For example, are you familiar with the expression: “Investing in the stock market is just like gambling at a casino”? If so, you may confuse investing with gambling. Although both activities involve risk, they have distinct differences. Let’s clarify the meaning of several financial terms.

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”

Robert G. Allen

Saving. Saving is putting money aside for the future with the primary goal of capital preservation. Thus, saving refers to money that you don’t spend or put at risk. Saving is a passive activity for short-term goals such as building a “rainy day” or emergency fund. Examples of savings vehicles include bank savings accounts, money market accounts, and certificates of deposit. These instruments are highly liquid, or easy to cash out, and considered extremely safe. You can quickly and easily get your money if needed. Because of their relative safety, such instruments offer the lowest returns of all short-term investments. Because a savings account interest rate is so low and may not even keep up with inflation, you should also invest to earn higher returns over time.

“Investing is laying out a dollar of purchasing power and getting more back in the future.”

Warren Buffett

“An important key to investing is to remember that stocks are not lottery tickets.”

Peter Lynch

Investing versus gambling. Investing is committing money to owning property, businesses, and other investments to earn long-term economic profits. Gambling is betting money hoping for a payoff if a random event outside of your control occurs, such as winning a lottery or picking the winner of a football game. It’s nothing more than luck and often bad luck at that. Savvy investors commit their money in a strategic way to accomplish specific goals like building long-term wealth for retirement. Investing is based on something tangible such as a stock, bond, or real estate, whereas gambling is based on luck. Investors expect to benefit as the company’s revenues and profits grow and to earn positive returns over time. Almost all gambling involves risk with a negative expected return. For example, with all lotteries and casino games, the expected return is negative because those running the game, referred to as the house, take their cut of the action. Because the odds always favor the house, the house wins in the long run and often the short and medium run as well. Casinos make lots of money because most glambers lose money. Investing enables you to diversify your risk across different asset classes lessening your potential loss, whereas gambling could wipe out your entire bet very quickly. As an investor, you can avoid losing all your capital by diversifying, or selling when needed. In gambling, you can’t stop your losses on a bet and get part of your money back. You either win or lose. With gambling, your chance to profit ends as soon as the wager ends, but with investing you have an opportunity for future income and capital growth. Thus, investors have a longer time perspective than gamblers.

“Calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic.”

Warren Buffett

Trading. Trading is the act of buying and selling securities within a short time period. Although investors buy and sell, they do so infrequently and hence don’t attempt to profit from short-term price discrepancies in the market. In a perfect world, traders would unload losers quickly to avoid further losses and sell winners to lock in a profit before the next price drop occurs. But that’s not what usually happens. Most active traders, such as day traders, lose money in the long run. A day trader is someone who buys and subsequently sells various financial instruments, typically before the end of the trading day. Despite the lure of day trading, such gambling-like behavior is hazardous to your wealth. Why? No theory can predict market behavior well enough to consistently forecast what will happen next. In fact, one research study reports that monkeys throwing darts at The Wall Street Journal stock pages could achieve better results than typical stock traders. Although the media report some sensational accounts of traders, some of these “success stories” are likely a result of luck, not skill. Think about the phenomenon of a stopped clock: despite not working, it still displays the correct time twice a day. Also be aware that a blind squirrel finds an acorn every now and then. Don’t be a monkey, a broken clock, or a squirrel, be a savvy investor and not a trader.

“Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little.”

Fred Schwed Jr.

Speculating. Speculating is like trading in that it’s usually associated with short-term transactions and a high degree of risk focusing on price fluctuations. Unlike traders who emphasize existing trends, speculators try to forecast future prices hoping to make a profit before the trend ends. Speculating can also be viewed as a form of “financial gambling” because the speculator attempts to forecast future prices. For example, consider penny stocks. Although a penny stock was once defined as a stock selling for less than $1, the Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below $5. Because companies with short or erratic performance histories are considered highly speculative stocks, penny stocks are inappropriate for investors trying to build long-term wealth. Additionally, the risk of fraud makes investing in penny stocks a dumb idea, especially for beginners and inexperienced investors. Savvy investors should avoid penny stocks.

2.2. WHAT ARE EQUITY SECURITIES AND THEIR MAJOR CHARACTERISTICS?

When you invest in equity securities, you own a piece of a business. A corporation issues stock to raise capital for several reasons: launch new projects, expand into new markets and regions, enlarge or build new facilities, or repay debt. It sells shares of its own stock for the first time through an initial public offering (IPO). This is called going public and requires a company to follow certain regulations to disclose its financial statements.

By owning equities, you can profit from the future success of a business. As a part owner, you’re entitled to a portion of that corporation’s earnings and assets. As a common stockholder, you typically have voting rights but aren’t guaranteed dividends. Given your residual claim on a firm’s earnings, you may receive dividends, but only after the company has paid interest to its debtholders and dividends to its preferred stockholders. In the event of firm bankruptcy, you’re the last to receive any payments and there usually isn’t much, if anything, left. As an owner of preferred stock, you usually don’t have voting rights but have a higher claim on earnings and assets than do common stockholders. You often receive scheduled dividend payments.

Some investors may prefer owning preferred stock instead of common stock because preferred stockholders have a greater claim to a company’s earnings and assets. Generally, investors buying preferred stocks do so because these stocks tend to pay larger and more stable dividends and to have lower volatility than that company’s common stock. However, common stockholders participate in a company’s growth through increasing dividends, whereas preferred stock dividends are usually fixed. Thus, investors consider investing in preferred stock as an alternative to bonds because of the attractive dividend yield. You should keep in mind that the overall investment risk of owning preferred shares is riskier than bonds. By contrast, preferred stock has less potential for profit than common stock due to lower overall risk.

2.4. HOW DO COMPANIES DISTRIBUTE PROFITS TO INVESTORS?

A company may choose to pay out some of its profits to investors in two main ways: dividends and share repurchases. Both methods transfer cash from the company to its investors.

Dividends. A company can opt to pay a cash dividend on each of its outstanding shares, which disburses some of its earnings to shareholders. You can use the cash dividend as you see fit – pay personal expenses, invest elsewhere, or automatically reinvest in the same company if it has a dividend reinvestment plan (DRIP). A DRIP is a plan that a corporation offers to allow its investors to reinvest their cash dividends into additional shares of the underlying stock on the dividend payment date. Unless you hold the stock in a retirement account, you must pay taxes on the cash dividends. Mature companies that can’t reinvest these funds in their growth are more likely to pay a cash dividend to investors than young, growing companies. A cash dividend reduces a company’s share price by an amount close to the dividend paid on the ex-dividend date. If you buy a stock on its ex-dividend date or after, you won’t receive the next dividend payment.

Share repurchases. A company can also buy back its own shares. Although you don’t have a choice on whether to receive a cash dividend, you can decide whether you want to sell your stock back to the company. If you do sell, you may face potential tax consequences in the form of capital gains or losses. Buying back shares might be done for four main reasons: (1) a good way for a company to use extra cash, (2) a ploy to boost earnings per share because the company’s net income remains the same but its average number of outstanding shares decreases, (3) a signal that it has run out of good ideas for investing cash, or (4) a boost to the stock price when investors believe its shares are undervalued. If a company repurchases its shares because its stock is highly undervalued, the repurchase program would be an appropriate use of funds and likely increase investment value.

2.5. WHAT METHODS ARE AVAILABLE TO ANALYZE STOCKS?

“Price is what you pay. Value is what you get.”

Warren Buffett

The two most common approaches to analyzing stocks are fundamental analysis and technical analysis. A third method is called quantitative analysis.

Fundamental analysis. Fundamental analysis asks an intuitive question: “What’s the business really worth, and what’s the current stock price relative to that value?” It’s an analytical approach used to gauge a stock’s true or intrinsic value by focusing on underlying financial and economic factors affecting a company’s business and its prospects. Intrinsic value refers to what a security should sell for based on reasonably detailed analysis. Fundamentals include any quantitative and qualitative factors affecting a company’s value, such as its revenues and profits, growth prospects, market share, and quality of management. Increasingly, investors are also looking at environmental, social, and governance (ESG) factors. Fundamental analysts place special attention on a company’s financial statements such as its income statement, balance sheet, and cash flow statement.

“When stock can be bought below a business’s value it is probably the best use of cash.”

Warren Buffett

“The secret to investing is to figure out the value of something – and then pay a lot less.”

Joel Greenblatt

An underlying assumption of this approach is that while the stock’s market price may not always fully reflect its intrinsic value, the market price will eventually reflect those fundamentals. Thus, fundamental analysis focuses on long-term stock price movements. It tries to determine if the company’s stock is a good investment by making long-term investments in a stock’s underlying business. When a company’s stock price is below its intrinsic value, savvy investors buy shares because the shares are undervalued. Thus, fundamental analysis is important in stock picking.

Critics of this approach contend that all major participants in publicly traded markets have access to the same information and so the market efficiently incorporates this information. In other words, they maintain that you can’t consistently find stocks mispriced from their intrinsic value, so fundamental analysis offers no real advantage. Others claim that much of the fundamental information is “fuzzy” and thus subject to personal interpretation and experience.

Technical analysis. Technical analysis is a technique designed to forecast the direction of prices by studying historical market data such as price and volume. A company’s past price movement and volume are purported to reflect the collective behavior of buyers and sellers. This method assumes that supply and demand alone determine prices. Technical analysts believe that price patterns repeat themselves, so the only thing that matters is identifying the patterns. They claim that using this approach can help investors anticipate what is “likely” to happen to prices over time by using chart patterns and other statistical indicators. Because technical analysis takes a short-term approach to investing, it provides a tool for traders.

Critics question the technique’s validity based on a lack of supportive empirical evidence. In fact, the preponderance of the evidence is damning − technical analysis typically hasn’t produced positive risk-adjusted returns over time. A risk-adjusted return measures how much risk is involved in producing an investment’s return. It’s useful because this measure enables you to compare the performance of a high-risk, high-return investment with a less risky and lower return investment, that is, to make “an apples to apples comparison.” Others view technical analysis as wishful thinking and no more useful than reading tea leaves. According to still others, savvy fundamental analysts take money from less knowledgeable technical analysts over the long run.

Quantitative analysis. Quantitative analysts focus only on the numbers, not qualitative factors about a company, when making decisions. Advances in computer technology and the availability of vast quantities of public data have enabled “quants” to rapidly crunch enormous amounts of data and to identify patterns. This ability creates complex strategies that establish automatic triggers to buy and sell securities. If too many investors use the same signals, then the market may crash.

Advocates claim that investors can use quantitative analysis both to achieve profitable security trades and to reduce risk. This dispassionate approach to decision making avoids the potentially detrimental effects of emotions and is also cost-effective. Despite these potential benefits, the process used in quantitative analysis is by no means foolproof. It also may take considerable training in data analytics and access to real-time data. As such, mostly institutional investors employ quants. You can think of institutional investors as the pro athletes of the investing game. The group consists of mutual funds, pension funds, endowment funds, hedge funds, banks, insurance companies, and other types of large investors.

“You can use all the quantitative data you can get, but you still have to distrust it and use your own intelligence and judgment.”

Alvin Toffler

2.6. WHAT TYPES OF INVESTMENT STRATEGIES ARE AVAILABLE FOR STOCKS?

When considering buying a car, you’re likely to follow your personal preferences to help you sort through all the models available. Similarly, you must figure out what investment style works best for you. You’re likely to ask yourself such questions as: What financial goals do I want to achieve? How much risk am I willing to take? What’s my time horizon? What returns do I expect to earn? Answering such questions enables you to identify those stocks that are right for your portfolio and those that aren’t. Not surprisingly, various strategies are available for choosing stocks, each having its proponents and critics.

Income investing. Income investing involves buying securities that tend to pay dividends on a regular basis. Following this strategy, investors buy income stocks mainly for the stream of dividends they generate, not capital appreciation. A high-yield stock is a stock whose dividend yield exceeds the yield of some benchmark such as the 10-year US Treasury note. Common examples of high-dividend payers include companies in the utilities and financial institutions industries.

Because income stocks aren’t always a safe bet, you should examine risk factors such as (1) the industry in which the firm operates, (2) its size, (3) the company’s amount of operating and financial leverage, and (4) its current valuation multiples, such as the price-to-earnings (P/E) ratio, relative to other companies in its industry. Operating leverage and financial leverage are metrics used by investors to determine a company’s financial health. Operating leverage indicates how a company’s costs are structured (fixed or variable); financial leverage refers to the amount of debt used to finance a company’s operations. A multiple is a ratio that is calculated by dividing an asset’s market or estimated value by a specific item on the financial statements or other measure. Common multiples include P/E or price-to-book (P/B) ratios. Thus, as a savvy investor, you should look beyond the dividend yield to other key factors that might help to influence your investing decision.

“All intelligent investing is value investing – acquiring more than you are paying for.”

Charlie Munger

Value investing. The marketplace isn’t always correct in its valuations, particularly in the short term. Value investing is a “buy cheap and sell dear” strategy in which investors buy stocks when prices and sentiment are depressed and sell when prices and sentiment rise. Sentiment describes the general mood among investors about a market or security. The difference between a stock’s market price and its true or intrinsic value is called the margin of safety, which provides a cushion on the downside if the stock turns out to be worth less than its estimated intrinsic value. Value stocks are stocks that generally trade at a lower price relative to their fundamentals such as sales, earnings, and dividends. For example, if Walmart’s P/E ratio is lower than the average P/E in its retail industry, then Walmart could be considered undervalued. Thus, the goal of value investors is to seek bargain purchases or unappreciated stocks that the market undervalues. If you properly identify value stocks and are patient in following a buy-and-hold strategy, you’re likely to reap handsome rewards as the market eventually realizes the undervalued nature of these stocks and bids up their prices. These companies often pay relatively large dividends so this can be a win-win situation.

Growth investing. Growth investing is an approach used to invest in companies exhibiting signs of above-average growth compared to the average for their industry. Sometimes these stocks may seem expensive given high price multiples in terms of metrics such as P/E and P/B. These signs could indicate the firm is a first-mover or in an emerging industry with sustainable competitive advantages over others in the field. Other potential signs of growth stocks are good management, consumer appeal, strong financial statements, past price appreciation, and a sustained high P/E ratio. Growth investors seek returns from future capital appreciation of this highly volatile class of stock that typically doesn’t pay cash dividends. Instead of paying dividends, a growth company reinvests cash in its business to fund a high growth rate. Growth investors believe that the growth in a company’s revenue or earnings will eventually be reflected by an increase in share prices.

GARP investing. Growth at a reasonable price (GARP) is an equity investment strategy that represents a fusion of value and growth investing to select individual stocks. GARP investors try to identify undervalued companies with solid sustainable growth potential to get a “double play.” Under some conditions such as highly uncertain markets, growth stocks may trade at a large discount relative to their business prospects as investors move to more defensive strategies such as value investing, thus reducing the demand for growth stocks.

Size-based investing. Some investors limit their investments based on company size in terms of market capitalization (cap) or revenue. Although no consensus exists on the cutoffs, a common classification of publicly traded companies is to group them into large cap (greater than $10 billion), mid-cap ($2 billion to $10 billion), small cap ($250 million to less than $2 billion), and micro cap (less than $250 million). Not surprisingly, you’re probably more familiar with large-cap stocks such as Apple (AAPL), Amazon.com (AMZN), and ExxonMobil (XOM), than small-cap stocks. Note the stock ticker symbols are shown in parentheses.

According to research evidence, company size is related to returns with smaller companies generating higher returns in the long run. Compared to larger companies, smaller companies are riskier, can grow faster, and have less media and analyst coverage. If you’re willing to take more risk and have a longer time horizon, increasing the allocation of your portfolio to small-cap and mid-cap stocks is likely to provide higher returns over time. However, if you want less volatility and have a shorter time horizon, holding a larger allocation of large-cap stocks could be desirable. Large, well-established, and financially sound stocks that generally pay dividends are called blue-chip stocks.

Momentum investing. Momentum investing involves a strategy that tries to capitalize on the continuation of an existing market trend. This approach results in buying stocks with upward-trending prices (returns), say over the past 3–12 months, and short selling stocks experiencing downward-trending prices (returns). Short selling is a trading technique that tries to make a profit when prices fall. It involves borrowing shares, typically from a broker’s street account, and selling them at the current market price in anticipation of eventually repurchasing those shares at a lower price and then returning the borrowed shares to the lender. The underlying rationale behind momentum investing is the belief that an established trend is likely to continue. This short-term strategy relies on various technical indicators rather than on a firm’s operational performance. A weakness of following a pure momentum strategy is that you could end up buying some very expensive and/or low-quality stocks. To mitigate this weakness, you could focus on cheap (based on their P/E ratio) but high-quality value stocks that are showing momentum.

Screen-based investing. Screen-based investing is a technique used to screen companies based on various quantitative criteria. With socially responsible investment (SRI) screening, companies meeting specific ESG criteria would be included (positive screening) and those with objectionable attributes would be left out (negative screening). For example, SRI investors intentionally exclude companies whose products or services violate certain ESG principles such as “sin stocks” or companies with substantial revenue from alcohol, tobacco, gambling, or firearms. After screening narrows the field, you can then more closely examine only the companies that meet these criteria.

2.7. IS A BUY-AND-HOLD STRATEGY RIGHT FOR YOU?

“Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.”

Warren Buffett

As its name suggests, buy-and-hold is an investing strategy in which an investor buys stocks and then holds them for an extended period even when markets are uncertain. The underlying logic of this popular strategy is that the stock market tends to increase over time. Although large gains in stocks can occur over a small number of market days per year, trying to identify those days in advance is a fool’s game. Therefore, you need to keep your money invested for the long term to take advantage of such advances in stock prices. By building a portfolio that meets your long-term goals and reflects your risk tolerance, you can stay invested even in volatile markets without losing sleep. A buy-and-hold strategy is practical for some investors, especially those who have less interest in learning about investing, can accept the risks, and prefer passive investing. Investors often follow this strategy in retirement accounts.

A buy-and-hold strategy has both advantages and disadvantages.

“The single greatest edge an investor can have is a long-term orientation.”

Seth Klarman

Advantages. A buy-and-hold approach works well during some periods, particularly bull markets when stocks continue to rise. It’s also easy to implement, involves fewer headaches than market timing, reduces commissions and fees due to lower trading, and saves on taxes by taking advantage of the low long-term capital gains tax rates. By remaining in the market and ignoring the short-term noise, your mistakes tend to smooth out over time. You don’t get in and out of the market at the wrong time. Although you’re generally better off staying in the market, many investors panic and sell. They believe they will see the bottom coming and get back in, but they’re usually wrong. Time in the market is more important than timing the market. Nevertheless, even long-term buy-and-hold investors should pay attention to the market but not necessarily on a daily or even a monthly basis.

Disadvantages. Of course, investing is not “one size fits all.” No investment strategy is right for everybody. By following a buy-and-hold strategy, you tie up your capital for the long haul. If your initial portfolio consists of duds or laggards or stocks that you bought at premium prices, it may not initially perform well. You could also suffer substantial losses during market downturns and crashes by ignoring market analysis. A “set it and forget it” strategy can be especially damaging during a bear or down market when prices are dropping. Furthermore, you could lack the discipline to hold losing investments in a bear market and bail out just before the recovery. Thus, buy-and-hold works until it doesn’t.

2.10. HOW DO YOU SET UP A BROKERAGE ACCOUNT AND WHAT TYPES OF ACCOUNTS ARE AVAILABLE?

Assume that you plan to open a brokerage account. When you set up an account, your broker normally asks whether you want to open a cash account or a margin account. You can also open a separate account for retirement investing.

Cash account. In a cash account, you pay the full amount of securities purchased. You deposit cash into this account in several ways: by writing a check, transferring money or linking it to a checking or savings account at your bank. Either way, you need to have the money in the account to buy securities.

Margin account. In a margin account, you can borrow against the value of the assets in your account to buy securities. The amount borrowed is called margin debt or a margin loan. Your broker lends you money to buy securities and uses the investments in your account as collateral for that loan. Trading on margin is investing with borrowed money, also known as using leverage. Be aware that brokers charge interest on the loan, which is tax deductible.

Margin refers to the amount of funds contributed to a margin account from your own resources and is also called your equity. This concept is a little tricky. Since a margin account allows you to borrow, many people think that margin refers to your loan. It doesn’t. It refers to your equity, which is the portfolio’s value less the debt. For example, if the initial margin requirement is 60% and you want to buy $10,000 worth of securities, your margin (equity) would be $6,000, and you could borrow the rest ($4,000) from your broker. A margin requirement is the percentage of marginable securities that you must pay in cash. Buying on margin enables you to obtain more securities than you can buy with just your available cash.

2.11. SHOULD BEGINNING INVESTORS USE MARGIN ACCOUNTS?

At first glance, buying stock on margin seems like a great way to enhance your return. If you earn a higher rate of return on the investment than the interest rate on the loan, using margin is profitable. But if the investment return is lower than the loan rate, you lose money. Thus, this investment strategy can amplify your gains or exaggerate your losses. New or inexperienced investors should avoid margin trading.

Buying stock on margin is a double-edged sword. For example, if you invested $10,000 and it increased to $12,000, you would have earned 20.0%, or $2,000/$10,000, during the investment’s holding period. Yet, if you had only invested $6,000 and borrowed the remaining $4,000, your return would be about 33.3%, or $2,000/$6,000, before paying the interest costs on the borrowed funds. Of course, if your portfolio decreased from $10,000 to $8,000, then the all-cash portfolio would have lost 20.0%, but the margined account would have lost 33.3% plus paying the interest cost. Therefore, trading on margin magnifies both losses and gains relative to an investment on a strict cash-only basis. These examples, however, don’t include the cost of paying the interest on the loan.

Not surprisingly, buying on margin has both pros and cons.

Advantages. Traders try to stack the game in their favor by using other people’s money, namely taking loans from their brokers, hoping to win bigger. Sometimes this approach works; sometimes it blows up in their faces. Warren Buffett warns against borrowing money to invest in stocks, noting that greed is a primary driver of margin debt. Buying on margin also enables taking advantage of trading opportunities and could be used to diversify your portfolio.

Disadvantages. Margin trading involves several risks including amplifying your losses. If the value of your investment plunges, a broker can demand a cash replenishment of the account, referred to as a margin call, or liquidate the portfolio without asking you. This situation happens when prices drop quickly and you lose money. So, the broker is forcing you to sell low – not a winning strategy. Each brokerage house sets its own maintenance margin, which is the minimum percentage of equity that must be maintained in a margin account. Thus, you need to be particularly vigilant in monitoring your accounts and portfolios. Finally, margin accounts require interest charges than can add up over time.

2.13. WHAT ARE SOME BASIC TYPES OF ORDERS?

The most common trading order types are called market, limit, and stop orders. When you place an order to buy or sell stock, your broker determines to which market to send your order for execution, even if you trade through an online brokerage account. Your broker is obligated to seek the best execution that’s reasonably available for your order.

Market order. The simplest order type is a market order, which is an order to buy or sell a security immediately. Although this type of order doesn’t guarantee the execution price, it assures the order’s execution. You should use a market order when certainty of execution or speed is more important than the execution price.

Limit order. A limit order enables setting a maximum purchase price for a buy order or a minimum sale price for a sell order. A buy limit order is executed at the limit price or lower, and a sell limit order is executed at the limit price or higher. For example, suppose you want to buy shares of a stock for no more than $50 and submit a limit order for this amount. Your order would only be executed if stock’s price is $50 or lower.

Stop order. A stop order is an order to buy or sell a stock once the stock reaches a specified price, called the stop price. Upon reaching or crossing through the stop price, your order is sent to the exchange as a market order. Traders usually place stop-loss orders when they initiate trades to limit their loss on a security position. For instance, if you set a stop-loss order for $45, or 10% below your initial $50 purchase price, you limit your loss to $5 or 10%, if prices were to decline. Thus, the intent of such orders is to limit your loss on a position in a security. You can also use a stop order to lock in a profit and sell when the price hits a target price.

2.14. WHAT COMMON MISTAKES DO INVESTORS MAKE WHEN INVESTING IN STOCKS?

No one likes to lose money. Yet, rookie investors are more likely to commit investment sins than seasoned market pros. Although the types of investing mistakes are practically endless, here are five widespread and costly investing errors to avoid.

“The most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price and no new buyers are left to emerge.”

Howard Marks

Trying to time the market. A frequent mistake when investing in stocks, especially for beginners, is trying to find the best time to enter or exit the market, which is called market timing. No one can always buy and sell at exactly the right time. Expecting that you’ll get in at the bottom and out at the top of a market cycle is unrealistic. The market’s future is rarely clear and there’s no “safe” time to invest. Because market timing typically doesn’t yield superior results, it’s unappealing to savvy long-term investors. About the best that you can expect is to identify major changes in market trends as they emerge such as the demise of MySpace versus Facebook and Blockbuster versus Netflix.

“Market timing is impossible to perfect.”

Mark Rieppe

Failing to properly diversify. Novice investors who have little money to invest often make a big mistake by owning stock in just one or two companies or industries. If you do, you’re taking too much risk by “putting all of your eggs in one basket.” When you diversify, you spread out your potential gains and losses over different investment classes. Thus, if one investment loses money, some other invest-ments may make up for those losses. Although diversification doesn’t guarantee that your investments won’t suffer if the market crashes, it helps to provide a smoother ride. If you have limited funds to invest, Warren Buffett suggest that you’re better off sticking with low-cost index funds and broadly diversified ETFs instead of owning just one or a few stocks. This sound advice by Buffett tells you how to make lots of money without being Buffett. A key component to long-term investment success is proper diversification, not only by industry and asset class but also geographically.

“Diversify. In stocks and bonds, as in much else, there is safety in numbers.”

John Templeton

Being swayed by emotions. The old Wall Street saying “Bulls make money, bears make money, pigs get slaughtered” warns investors against excessive greed. As an investor, you can make money when the market outlook is positive (a bull market) and when it’s negative (a bear market) but avoid being swayed by emotions and becoming a pig by taking overly large positions. Greed and fear are twin emotions when investing.

Savvy investing isn’t about following your emotions, instincts, or “gut” feelings. It’s not about the temptation to buy into the latest hot-performing stock or that elusive “can’t-miss” investment. If you’re unable to control your emotions, you’re less likely to profit from the investment process. Unfortunately, investors often forget sound investment principles at the top of the market when everyone has already jumped on the boat and at the bottom when they have jumped off. Savvy investors exercise considerable willpower to keep from being influenced by the crowd. When everyone rushes to one side of the boat, you should move to the other side to avoid getting soaked. When making investing decisions, your emotions are often a reverse indicator of what you ought to be doing. Thus, don’t be afraid to be a contrarian and to avoid following the crowd.

“Unless commitment is made, there are only promises and hopes; but no plans.”

Peter Drucker

Not committing to a long-term investment plan. Beginners often have an on-again, off-again approach to investing, which doesn’t work well if their goal is to build wealth. You may buy a stock, experience a loss, and subsequently lose interest in investing. To reach your financial goals, you need to start early, invest regularly, and follow a well-conceived financial plan during all of the market’s ups and downs. When investing in stocks, time is your best friend so be patient. Planning enables you to bring the future into the present so that you can take some action now. By staying committed to a realistic plan, you’re more likely to achieve greater rewards over time. Otherwise, as Yogi Berra, the famous New York Yankees catcher, noted: “If you don’t know where you’re going, you’ll end up someplace else.”

“Know what you own and why you own it.”

Peter Lynch

Investing in something you don’t understand. Common sense suggests that you shouldn’t invest in something you don’t understand. As Albert Einstein once said, “If you can’t explain it to a six year old, you don’t understand it yourself.” Peter Lynch expressed a similar idea when he said, “Never invest in any idea you can’t illustrate with a crayon.” You should also heed Warren Buffett’s advice of staying within your circle of competence. Before investing in a stock, you should understand the strengths and weaknesses of the business in which you’re investing. Don’t simply rely on someone’s recommendation or tip. Unless you do some research yourself, you won’t know if the stock is right for you. You especially need to understand its downside risk, which is the financial risk associated with losses.

2.15. WHAT ARE SOME INVESTMENT SITES TO HELP LEARN MORE ABOUT STOCK INVESTING?

Here are some websites that provide information about stock investing.

Investopedia (https://www.investopedia.com) is a leading source of financial content on the web that focuses on investing and financial education and analysis.
The Motley Fool (www.fool.com) is a financial services company that provides financial advice for investors through various stock, investing, and personal finance services.
Seeking Alpha (https://seekingalpha.com) offers a crowd-sourced content service for financial markets including articles and research covering a broad range of stocks, asset classes, ETFs, and investment strategies.
The American Association of Individual Investors (https://www.aaii.com) is a nonprofit organization whose aim is to educate individual investors about stock market portfolios, financial planning, and retirement accounts.
The Street.com (https://www.thestreet.com/topic/47701/how-to-invest-in-stocks.html) is a financial news and services website that provides a host of online resources for investors.
Wall Street Survivor (www.wallstreetsurvivor.com) is an educational website that teaches the basics of finance using gamification to convey concepts of the stock market, investing, and general financial planning.
The US SEC maintains a website (https://www.investor.gov) that provides unbiased information to help you evaluate your investment choices and protect yourself against fraud.
Moneypaper is the publisher of The Guide to Direct Investing Plans and is the owner/manager of the directinvesting.com website (https://www.directinvesting.com). This site explains the advantages of investing directly in US stocks thereby bypassing brokers and fees.

2

THE STOCK MARKET: OWNING A PIECE OF COMPANIES

2.1. WHAT DO THE FOLLOWING TERMS MEAN – SAVING, INVESTING, GAMBLING, TRADING, AND SPECULATING?

2.2. WHAT ARE EQUITY SECURITIES AND THEIR MAJOR CHARACTERISTICS?

2.3. WHAT ARE THE PROS AND CONS OF INVESTING IN STOCKS?

2.4. HOW DO COMPANIES DISTRIBUTE PROFITS TO INVESTORS?

2.5. WHAT METHODS ARE AVAILABLE TO ANALYZE STOCKS?

2.6. WHAT TYPES OF INVESTMENT STRATEGIES ARE AVAILABLE FOR STOCKS?

2.7. IS A BUY-AND-HOLD STRATEGY RIGHT FOR YOU?

2.8. WHAT TYPES OF STOCKS ARE BEST FOR YOU?

2.9. HOW ARE STOCKS BOUGHT AND SOLD?

2.10. HOW DO YOU SET UP A BROKERAGE ACCOUNT AND WHAT TYPES OF ACCOUNTS ARE AVAILABLE?

2.11. SHOULD BEGINNING INVESTORS USE MARGIN ACCOUNTS?

2.12. SHOULD NOVICE INVESTORS ENGAGE IN SHORT SELLING?

2.13. WHAT ARE SOME BASIC TYPES OF ORDERS?

2.14. WHAT COMMON MISTAKES DO INVESTORS MAKE WHEN INVESTING IN STOCKS?

2.15. WHAT ARE SOME INVESTMENT SITES TO HELP LEARN MORE ABOUT STOCK INVESTING?

2.16. TAKEAWAYS