Four Principles of Investing

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There are four principles of investing that everyone should have a firm understanding of if they want to be a great investor. These principles are not complicated by any means, but they are GUIDELINES for you to follow to help you invest successfully for years to come.

Invest Regularly, Regardless of Market Outlook

When you first begin investing you are going to have a tendency to question every decision that you make. I guarantee that you will purchase a stock, and if that stock goes down or trades sideways you are going to wonder if you made the right decision. For beginners, it is completely natural to obsess on your first investments and question your decisions. Sure you will make some mistakes, but if you work through them, in time you will become less fearful and a better investor.

Remember that the value of stocks has increased by an average of over 11% per year for the past 76 years despite cycles of boom, recession, depression, and recovery. Over the long-term, simply by investing in the stock market you will win-and win big.

More often than not, you do not want to invest a large sum of money all at once. There are two main reasons for this:

  1. Attempting to time the market (buy at the lowest lows and sell at the highest highs) is extremely difficult. Even the most experienced investors cannot time the market to this degree. Plus in today’s day and age, one errant Tweet from the president can send the market into a brisk pullback. Rather than spend hours and hours attempting to time the market perfectly, invest regularly, and when the market pulls back contribute a little extra.
  2. Investing small amounts regularly can calm beginners’ jitters, not to mention improve your results. The technique called dollar cost averaging, is simply investing a fixed amount of money on a regular schedule. When you do that, you automatically buy more shares when the price is lower and fewer when the price is higher. The result is a lower average purchase price and a higher overall return.

This is not rocket science! To make a case for investing regularly: If you invest just $1.00 a day in from your 15th birthday until you reach the age 65 (a total contribution of about $18,250) and achieve a 10% annual rate of return, your money would grow to approximately a half a million dollars.

Reinvest All Earnings

There are two primary ways in which companies can use their earnings:

  1. They can reinvest the money back into the company to help it grow.
  2. They can distribute the earnings back to shareholders through dividends or share buybacks.

Although the small amount money returned to shareholders in the form of a dividend might seem underwhelming, don’t overlook dividends. Reinvesting those small dividends over time boosts your investment return significantly!

Reinvesting the dividends that companies pay to you works similarly to the way rabbits multiply. When the offspring start to have babies of their own, the hutch gets crowded in a hurry. Well, when dividends start earning dividends, the dollars in you account start stacking up.

Earning dividends on your earnings is called compounding. It’s hard to explain, but the results are magnificent. If you invested $100 in the S&P 500 index in 1926 and spent all the dividends you received, you would have amassed $10,350 by the end of 2000. If you reinvested those dividends, you’d have a total of $258,652!

If you invested $100 in the S&P 500 index in 1926 and spent all the dividends you received, you would have amassed $10,350 by the end of 2000. If you reinvested those dividends, you’d have a total of $258,652

Invest in Quality Growth Companies

Don’t overthink investing in quality growth companies! In simple terms, growth companies generally increased their revenues and earnings faster than the overall economy and inflation combined. The ones to buy also grow faster than a lot of their industry competitors. It’s that simple.

So how do you find QUALITY growth companies? Well sometimes it is simple as using your five senses. Reach into your pockets and pull out what you have in them. I’m going to make a bold assumption that you are carrying some sort of credit card in your wallet, and a cell phone. These products are great products that are used by everyone, and if you look at the stocks of Visa (V), Mastercard (MA), and Apple (AAPL), all of these stocks have been GREAT GROWTH STOCKS!belt, cash, credit card

The easiest way to know whether or not you own a company in its growth phase is to look at its quarterly earnings report. If a company is consistently growing its sales and earnings >15-25% per year, chances are you have stumbled upon a company in its growth phase.

Understand that eventually all growth cycles slow as the company grows larger and larger. However, by analyzing both earnings and revenue growth, you can make sure the companies you own are in their growth phase.

Companies can continue to grow sales in a variety of ways:

  • Expanding territory
  • Increasing market share
  • Building new stores
  • Introducing new products or applications for existing products
  • Acquiring competitors
  • Increasing prices

Although all of the above are important aspects of growth, none of them are possible if a company has a lousy product. Look for companies who have products that are true industry disrupters or change the way we live, not just fad products.

Make sure you stress investing in high quality companies! You want to seeking out and invest in companies with improving operating margin, strong free cash flow, and a return on invested capital of at least 10%. These are all generally characteristics of some of the strongest companies.

Diversify to Reduce Risk

If you could pick the one company that was destined for years of double-digit growth, you would make the most money by investing all your cash in that one investment. However, statistically speaking, even when applying thorough fundamental research, approximately one out of every five stocks you buy will be a loser, three might achieve slightly better than market returns, and one will exceed your expectations.

The moral of the story in this scenario is that don’t want to put all of your eggs into one basket or put all of your money into one stock. Diversifying your investments reduces your risk. It prevents one mistake from wiping out a big chunk of your net worth. For example, a competitors new product or change in consumer preference could wipe out a small company you were sure was a winner (Look at GoPro (GPRO) for example).

Large companies might grow more slowly, but usually have the wherwithal to ride out some storms. Even industries rise and wane.

Investors dumped the health care industry for fear of the affects of proposed health care reform in the early 1990s. We also saw the technology sector totally imploded in the early 2000s in the dot-com bubble.

When you choose the stocks for your portfolio from a variety of industries and company sizes, you can earn a market beating return without riding an investment roller coaster.

If you are managing your own portfolio, don’t over-diversify. Do not own anymore than 10 holdings because otherwise there is just too much for you to keep track of and research. If you want more diversification, simply buy a market index fund.

Congratulations You’re Ready to Invest!

 

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