Basic Investment Rules – Part 3

July 9, 2012 — 24 Comments

Never Invest In Individual Stocks

Influenced by internal and macro (external) factors, a stock’s price can be tugged in opposite directions. With multiple factors to consider, an investor will have difficulty predicting which will triumph over the other and what the future price will be.

Because financial reports don’t reveal all the internal details about a company, it is nearly impossible for an outsider to comprehend growth prospects and management strength. Given the “unclassified” information that management selected, you’ll be blindly investing in individual stocks.

Also, there’s a risk that the stock you bought will go bankrupt. Because this does not apply to entire indexes as they can never fall to zero, you can average in and hold until you make money.

….. Also, Don’t Invest In Penny Stocks

Successful investing is all about calculating the odds of your investment working out. With penny stocks, you can’t calculate anything! The whole premise behind investing in a penny stock is that your investment can increase 1000% overnight, which we all know is not possible. Investing in penny stocks is synonymous with gambling.

Be Cautious About Shorting

To quote Hedgehogging, “shorts aren’t for the faint-hearted”. In it, an investor, The Prince of Darkness, shorted a casino stock which subsequently shot up, forcing him to liquidate at a large loss. Ironically, the stock tanked after he covered and had he been able to hold onto his short, would have made out like a bandit.

The moral of this story is that shorting, especially shorting individual stocks, is dangerous. Without accurate timing, an investor can be dead right but still lose money. An unprofitable long position can be held until it turns profitable, but an unprofitable short can be forced to liquidate due to margin requirements.

As a result, I believe that shorting should not be attempted unless you’re highly experienced and use quick stop losses.

Be Satisfied With a Good Return

Not satisfied with good return-on-investments, many investors hold onto their positions and hope to squeak out another couple of percentage points. According to Reminisces of a Stock Operator “the last eighth is always the most expensive eight.” A lot of money is lost by investors who try to squeeze a little more money from their positions. As a result, they deviate from their original plan and overextend their positions.

You Must read, Then Actually Invest, & Then Read Again, & Your Understanding of What You Read Will Deepen

Investors who don’t want to learn anything want to dive right into the markets. Others are so scared that they do nothing but read about how to invest without actually investing themselves. Here’s the correct path to take.

  1. Read as much as you can. It’s cheaper to learn from the mistakes of others than to repeat those same mistakes. There will be things in your readings that you won’t understand, but that’s ok. That’s why you need to actually invest with real money.
  2. Invest. Test out everything you’ve learned from your books. Only by actually investing can you truly experience the thoughts and emotions of a true investor, and only then can you test out whether your theories work in reality or not.
  3. Reread what you’ve read before. You’ll find a lot of new wisdom in your previous books because now, you can really understand what the books are talking about (relating your investment experience to those of the author).

24 responses to Basic Investment Rules – Part 3

  1. Is shorting the same as buying on margin? I have a coworker who has done that and it’s caused him some serious stress. I’ve only bought individual stocks when I worked somewhere and could get it at a decent discount (and knew the company!)

    • No. Shorting is essentially the same as betting that the price will go down (you profit if the price goes down, you lose money if the price goes up). Margin is another word for leverage (e.g. buying $10,000 worth of stock on $1000 in cash = $9000 borrowed on margin). Most brokers will tell you up to how much margin you can borrow.
      That’s smart. Invest in what you know, not what you don’t know.

  2. Nice suggestions. Penny stocks are the worst. And the people who fall for them are the junior investors because they think they can make the big money but it’s sort of like playing the lottery to me, or like you say, gambling. I don’t think I have to guts to buy penny stocks or short anything any time soon.

  3. When you short do you have to borrow the money on margin? I’ve never sold a stock short and probably won’t be getting into it anytime soon.

    Being content with a decent return is such an important thing. So many people in this country chase returns and we always let greed get the best of us.

    • You need to open a margin account to short a stock. It is in this account that the funds from your sale of borrowed stock will be placed, but also from which the money will be withdrawn once you cover that short. But you’ll need enough money in your actual account to post as margin. Like I said shorting is really hard because of the timing element, which is why I don’t attempt it.
      “A good return is often the best return.”

  4. I’ve never invested in single stocks, they’re just too risky for me. I prefer mutual funds, I understand them more and they can be a bit safer.

    I’ve only ever heard negative things about penny stocks and don’t understand them enough to invest in. I try to keep my investments simple and invest in what I understand.

  5. I’m not sure that ‘never buy individual stocks’ is applies in all cases. I think the message you are trying to get accross is that individual stocks increase your volatility and risk – something you need to be aware of. I own mutual funds in my RRSP and individual stocks in my TFSA. I am comfortable with a higher level of risk in my TFSA, as I accumulate individual Canadian dividend paying stocks accross a wide variety of sectors.

    I agree that index funds are valuable and I intend to convert my RRSP mutual funds to an index (to save on MER) in the next 6 months.

    • I guess this ranges from person to person. But you’re right, it does increase your volatility and risk, and the problem is, I can’t quantify this risk! (whereas in other areas I can quantify the increased risk).
      What I like about Canadian stocks is that a lot of them are commodity-related, which tend to do well in commodity bull markets.

    • I agree. I think ‘never buy individual stocks’ is a massive oversimplification. Yes, it’s harder for the average Joe to shoot himself in the foot with index funds but I would prefer not to think of myself as average. I’m not of average intelligence, age or height, so why do I care that the average person can’t pick a good company from a bad one? I know I can, and that’s all that matters to me. Using cost averaging to buy index funds gets so much coverage, and it’s safe for people who don’t have the time/inclination/skill to do better, but when buying index funds, you’re committing to buying cyclicals at the wrong time. You’re committing to owning companies that you don’t believe in for ideological, financial or strategic reasons. You’re committing to buying some companies at values you’d otherwise judge to be too expensive. All of this, in the name of being average.

      It’s interesting to read what the most successful fund managers like Peter Lynch and Anthony Bolton have to say about private investors picking individual stocks. They certainly don’t recommend avoiding it.

      • That all depends on what kind of an investor you are. But truth is, investing in the overall market is easier than individual stocks.

        • I have to agree with Ash – Some investors can do just fine with individual stocks. For some stocks, there is virtually no risk of bankruptcy, and if you diversify your individual stock investments, then you should be able to achieve a decent portfolio risk and likely avoid higher fees in the process. This could be an entire article series in itself. Pros and cons of investing in large caps, benefits/risks of investing in specific industries, how to get stocks for low transaction costs, etc.

  6. “Be Satisfied With a Good Return” – This rings very true to me where I fail many times over! I got to work on this!

    There are some stocks that is better off holding for long term vs short term. Several of the times, I let go of the good ones and kept the bad seeds. Although, I don’t whole heartedly agree with your first suggestion of “Never Invest In Individual Stocks.” I’m a big fan of stocks and have done well in them. You really got to do your research on the companies you buy. Other investment vehicles like mutual funds will erode over time eating up your return with high MER fees.

    Looking forward to hearing more stock tips from a pro!

    • Your right, but I find good research on individual companies really difficult to find, because stock research is done by analysts who are paid to say good things (or, if they want to say something negative, make it neutral).

  7. I can see where your advice is coming from, but I’m not really agreeing with the whole “Don’t Invest in Individual Stocks” advice. There’s lots of mixtures and tactics that can be used to help reduce your risk below even that of mutual funds – especially if you’re a value investor.

    Your quote: “Investors who don’t want to learn anything want to dive right into the markets. Others are so scared that they do nothing but read about how to invest without actually investing themselves.”

    100% agree! There was a time not long ago where I read book after book and finally said “Enough! I need to actually get out there and make some magic happen!” I’m glad I did because you learn just as much by actually doing it as you do when you read about it.

    • “There’s lots of mixtures and tactics that can be used to help reduce your risk below even that of mutual funds” You’re right, of course. I guess this defers from person to person. I find it difficult to reduce many unknown risks (e.g. management health).

  8. Good basic information!

  9. Aimee Fontenot July 16, 2012 at 1:55 pm

    This is some good info. I really know nothing about investing, so this will point me in the right direction.

  10. Stocks are confusing to me and too risky so I wouldn’t invest in them but I listen to Dave Ramsey and he always says he doesn’t recommend investing in single stocks instead put your money in mutal funds.

  11. Smart set of rules!

  12. I agree, with investing in penny stocks

  13. I think shorting should be left to people with more experience in the stock market.

  14. thanks for the tips

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