Stock investing is misunderstood by many, which is a key reason why many investors have missed out on the current bull market. It’s often viewed as too risky, confusing or most recently, rigged. Others turn the market into their own personal casino, looking to get rich quick, but leave empty-handed. However, when treated appropriately, the stock market is a remarkable opportunity that enables individuals to become partial owners and share in the fortunes of the world’s most remarkable companies.
Here are five tips to help make the stock market work for you:
1. Be a “shark” not “Fast Money.” The TV series “Shark Tank” provides valuable lessons for individual investors. For those that haven’t seen it, it is a reality show about aspiring entrepreneurs seeking capital from a panel of investors, or “sharks,” to help grow their business in exchange for an equity stake in their company. First, the “sharks” hear a business pitch and then ask questions about strategy, competition, growth trajectory and profitability to get a better feel on the company’s future prospects. Then, after determining whether the valuation is attractive in relation to the firm’s growth potential, the “sharks” decide whether to take an equity stake to share in its long-term fortunes.
On the other end of the spectrum is the CNBC show “Fast Money.” Here, traders talk about which stocks they like with time horizons measured in days, weeks and months. Certainly there are successful short-term traders, but this is an investing style that is often ill-suited for most individual investors.
The lesson here: Successful long-term investors know that it is better to be an “owner” of stocks – not a “renter.” In essence: Be a shark.
2. Know what you own and why you own it. One common mistake that individual investors (and some professional ones as well) make is that they don’t know much or anything about the stocks in their portfolio. They either received a tip from a friend or a co-worker, read something in a financial publication or saw a news segment that influenced their thinking. The problem is, investors could end up owning something far riskier than what they’d prefer, or, if the stock doesn’t initially move in their direction, they might sell too early, only left to tell the story of the one that got away. Of course most people can’t spend their days researching companies. However, a little bit of effort can go a long way. There is a wealth of information online, especially on the company’s “investor relations” website. There, individual investors often can find archived presentations made to professional investors that give a good synopsis of the firm and its strategy that typically only last 30 minutes.
A good exercise to try: Write down the top three reasons why it makes sense to own a stock. If tempted to sell, revisit that list and determine if the investment rationale is still intact.
3. Stick with quality. There are many characteristics that define a quality company. Professional investors consider firms with high profit margins, strong returns on capital, sustainable competitive advantages and healthy balance sheets. This accomplishes two things. First, it helps weed out riskier stocks. Sure, there is money to be made buying firms with high debt loads in capital intensive industries that trade at deep discounts, but this requires intensive research and carries considerable risk. Another benefit of focusing on quality is that it increases the chance that the decision is right, even for the wrong reasons. One of the best-performing recommendations of my career unfolded in a similar manner. This unloved company was a victim of the dot-com crash, but it has a unique product offering, strong margins and a cash-rich balance sheet. Although my investment thesis was correct, what eventually made the stock a 45-bagger was an acquisition that transformed the firm.
The bottom line: Good things can happen to good companies.
4. Volatility is not risk but can be opportunity. Volatility can turn any investor’s stomach and test their resolve. However, many incorrectly equate volatility with risk. Volatility is the price fluctuation of an asset. Risk is the permanent loss of capital. Volatility does not become risk unless an investor is forced to sell. In other words, investors that understand the difference and can set aside money for multiple years put themselves in a better position for success, especially if they are buying quality companies at reasonable prices. Even better, they can take advantage of those that get squeezed out of a position that turns volatile because they invested short-term money.
When investing in stocks: Don’t confuse price volatility with permanent loss of capital.
5. There’s no such thing as a free lunch. In this ultra-low interest rate environment, many yield-hungry investors have turned away from bonds towards dividend-paying stocks. However, simply picking stocks with the highest dividend yields can be dangerous. When the average dividend yield of the Standard & Poor's 500 index is roughly 2 percent, there’s a reason a stock may yield 8 to 10 percent. It’s riskier. Often these very high-yielding names have deteriorating financials, are loaded up with debt or are dependent upon capital raises to pay the dividend rather than internally-generated cash.
The same is true for value stocks, or those that carry low price-earnings multiples. There’s a reason these stocks trade at a steep discount to the broader market.
The bottom line: It is wise to understand why a stock is valued like it is before investing. Know the risks.
Stock investing is difficult and not for the faint of heart. It requires time, patience and resolve. Individual investors who are unable or unwilling to put in the necessary effort, should consider working with a financial advisor who has a strong research team that can help do the heavy lifting for them.
Brett Carson, CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.