How Not To Lose A Fortune On The Stock Market!
Copious reams, articles and books have been written on how to make a fortune on the stock market. And I am sure we all get tired of hearing how someone made a fortune being a forex trader, a day trader or by buying some obscure Canadian mining stock and for the price of a small subscription to a stock market newsletter the authors will promise instant wealth and success.
Well, the real world is not like that. We need to work for our money. And the first rule of making money is not to lose money. So for a change I thought I would turn things around and do an article on how not to lose a fortune on the stock market. Next month I will revert to more positive comments again.
Ensure your time horizon is appropriate. The stock market is probably not the place for you if your investment period or time horizon is less than two years. (Obviously this does not apply to stockbrokers, speculators, day traders or professional money managers). If your time horizon is less than two years, this means that at the end of this period you need the capital to be intact for some specific purpose e.g. university fees or a house purchase etc. It would be very upsetting if at the end of your short time horizon your original capital was no longer intact. In other words you need to be in cash or near cash. If your time horizon is say two to five years or longer, you can now happily consider a share portfolio.
Make sure your gearing is appropriate or don’t invest with borrowed money.
If you make a mistake with borrowed money you may not survive the experience. It is wiser not to do this at all.
Kiss. Keep it simple, stupid. Choose investments that are easy to understand with predictable cash flows. Don’t go for exotic businesses that are hard to value and which even the experts don’t understand. One of the easiest ways to lose a fortune on the stock market is to buy shares like these and then to average down as the price falls. i.e. to buy more shares as the price declines. Many fortunes have been lost in this way. Other investors just hold on to these losing positions mesmerised as the price keeps falling and believing that the share price can’t go any lower. But of course it can. It can go to zero.
Don’t put any emphasis on historical cost. It is mind boggling how many investors make this fundamental mistake. The price paid for a share is not in the least bit relevant to the buy, hold or sell decision. The only factors relevant now to valuation are the future cash flows. Ask yourself if this is a great company and whether or not the shares are undervalued. Nobody cares what you paid for the shares – always remember this.
Do not excessively diversify your portfolio. Warren Buffett calls over diversification the Noah’s Ark Technique :
“Investors buy two of everything and in the end they own a zoo”. The simple fact from a portfolio management point of view is that owning more than ten stocks adds little benefit in terms of reduced volatility. Holding less stocks also means you will concentrate your research and efforts and your best picks should perform better than those you purchased with less conviction.
Never buy on rumours or tips. This is a sure way of losing. There is an old stock market adage; “where there is a tip, there is a tap”. This simply means that the person giving the tip is selling his shares into the market as quickly as he can. Besides if the tip is genuine you may find yourself trading on inside information which is a criminal offence and believe me you don’t want to mess with this legislation.
Always do your own research or consult a professional portfolio manager.