The 10 Basic Principles of Investing

It's very likely that you'll try several investment strategies before you find the one that best suits your goals and investing style, but there are some basic investing principles that hold true for all strategies.

Whether you are reading biographies of the most famous investors of all time such as Warren Buffet, George Soros, or Peter Lynch, or you're reading recent articles by popular investment advisors such as Thurman Smith or Jim Cramer, there are a few key concepts that you will see repeated over and over again. After you read this section, you're sure to start noticing whenever they are mentioned. In fact, they come up so frequently, you'll find it hard to believe how few people adhere to them. Unfortunately, even great strategies can lose money if you don't respect the basic principles of investing. You're at an advantage as a beginner, you haven't formed any bad habits yet so keep coming back to this section until these concepts are ingrained.

Start Right Now

The right time to start investing is right now. People tend to be optimistic and happy to buy when the market is going up and pessimistic and likely to avoid investing when the market is going down. This is a mistake, when you have money to invest, put it to work, don't try to wait for the perfect moment or the perfect stock because they may never come.

Remember compound interest? It can't work for you if your money is on the sidelines. Many beginners have a very low risk tolerance and want to avoid losing any money. Paradoxically, they also often expect superior returns. It doesn't work that way, there is no such thing as risk-free investing if you want the average market return of 10% or better. Just remember that as long as you select a good long term strategy and adhere to the basic principles of investing, history has NEVER failed, you WILL make money.

Diversify Your Investments

Diversification is a fancy way to say “don't put all your eggs in one basket”. If you own the right number of stocks, bonds and funds and they are allocated across several categories, industries and geographies, you can substantially lower the risk of losses to your portfolio and increase returns at the same time. What?! That's right, if you diversify properly, you lower risk AND improve returns at the same time, making this a no-brainer. How does it work? Diversification is the process of finding the investing sweet spot where you optimize risk Vs return.

Uh oh, “optimization”, sounds mathy doesn't it? It sounds complicated but it's not. There are only three things you need to focus on as you create your portfolio to make sure you're creating diversity; the number of securities, the mix and asset allocation.

Owning between 25 and 30 securities is the optimal number. Less and you haven't truly diversified, your losers can still really hurt your overall returns. More and you get diminishing returns from too much diversification, you might as well buy an index fund and let it ride if you're going to carry 50 or more stocks. 25 to 30 securities is a lot, and many beginners don't have that kind of cash when they start investing. Don't worry, mutual funds were made for you, many of the best ones will give you full diversification with an investment as small as $500. We'll provide a full review of mutual funds later in this guide, their flexibility makes them one of our favorite investing strategies for beginners.

The second critical piece is the diversification mix. You want to invest in a wide variety of industries, categories and geographies to ensure that when one specific area goes south, it doesn't tank your whole portfolio. For example, if you own a telecom and suddenly the industry is getting bad press due to invasion of privacy lawsuits, the rest of your portfolio can cover the losses of that stock. Why? If you're diversified, that's probably your only telecom, the rest are in unrelated industries and won't be directly affected by these lawsuits. Also, your portfolio should be spread across a wide variety of categories and geographies, most of which won't correlate at all with anything going on in telecom, some may even be inversely correlated (meaning they do well when telecoms do poorly).

Finally, make sure you have a diverse asset allocation. This means make sure you spread your money between various types of investments, don't buy only stocks, bonds or funds, buy a combination. The reason you want a blend is because each type of investment behaves very differently. Stocks, for example, have the highest potential return of any type of investment but they also have the highest risk of losses. Bonds, on the other hand, can't provide the types of returns a stock can but they offer stability since their returns are often guaranteed. A blend of different asset classes is just another way to diversify and you can choose from a wide variety of allocations. Here is a good rule of thumb. The further you are from retirement the more you should allocate to more aggressive investments like stocks, and the closer you are to retirement the more you should allocate to shorter term lower risk investments like bonds.

Don't Lose Track of Your Investments

A mistake that you will inevitably make (we all do) is investing in a vacuum. What we mean is that, at some point, many investors quit learning, stop adjusting their investment strategy, and lose touch with the current market and economic conditions. This is a painful lesson to learn and unfortunately most people have to learn from it (or fail to learn from it) over and over again.

Why does this happen? Human nature. When you find a strategy that works over a long period of time ranging from a few months to several years, depending on the investor, you tend to gain a lot of confidence in your investing ability. While confidence is an important trait for an investor, it tends to settle you into a comfort zone. Many people have asked, “are you just saying that people shouldn't get over-confident?” No. Our point relates more to getting confident enough to slip into a comfort zone than a distinction between confidence and over-confidence. We are all guilty of this, it's a normal reaction.

The first side effect is that you will stop searching out new investing information to add to or challenge your own knowledge. When you believe you already know enough to invest well, it's hard to find the motivation to continue seeking out new information. This leads to the second side effect. When you aren't pursuing new knowledge, you can no longer improve, refine or adapt your investing strategy.

If you have stopped seeking knowledge and no longer adjust your strategy BUT your investments STILL do well, you will inevitably experience the third side effect. Since things are going so well with so little effort, you will begin losing touch with and interest in changing market and economic conditions. At this point you are in a complete investing vacuum.

No one, not even an index investor, can get away with this mistake unscathed. When you do realize your mistake, you'll have to catch back up on everything and, as every beginner learns quickly, learning curves can be steep and painful for those that fall behind. Whether it's reallocating to balance your portfolio or switching industries to continue finding value stocks, most strategies (good ones at least) will require some adjustments when the market and economic environments change. Because you didn't make these adjustments when you should have, not only do you have a learning curve to climb but you've already experienced losses that you could have avoided.

So how do you avoid the vacuum? The most successful approach we've seen is to discuss a wide variety of investing topics frequently. Don't worry if you're a beginner and don't know many investors yet. Finding people to talk to is as easy as a Google search, you'll be shocked by how many options are readily available. Want to check for yourself? Try searching for investing forums, investing discussion boards, or check any of the major investing sites for discussion areas. Prefer face-to-face interaction? Search your local area for investing clubs, free investing and personal finance seminars (meet other investors), or just talk to your friends, many of them may appreciate sharing the new knowledge you've picked up and will try to return the favor.

On the web, you're learning everything you need to know about investing, but when you talk to others you get to hear real life experiences. Absorbing the wisdom and knowledge of experienced and successful investors is a great way to learn, you can't beat on-the-job-training. When you are a more experienced investor, it's also fun and fulfilling to teach others and this reinforces your own knowledge. Interacting with others provides a fresh perspective, pushes you to continue learning, and sometimes even provides new insights that you can incorporate into your own investing strategy.

Investor Psychology: Don't Follow the Herd

I define Investor Psychology as the herd mentality that is so obvious when you watch short-term stock market behavior. It seems that most investors are willing to follow each other up mountains and off cliffs simply because that's what everyone else is doing. There are tons of outstanding examples to illustrate this lemming-like behavior, but we'll go with Google (GOOG) since it's a company almost everyone has heard of.

3/17/08:
Bear Stearns, a major investment brokerage, made some very bad bets on sub prime mortgages and was on the brink of bankruptcy. JP Morgan Chase and the Federal Reserve Bank announce a deal to buy out the troubled brokerage on 3/17. JP Morgan winds up paying an unbelievable $10 per share for a stock that had traded for $100+ per share only three months before.

Some professional analysts and news pundits begin clamoring that we can “expect to see multibillion dollar companies falling like dominoes in the weeks and months ahead.” They pronounce that we “may be going beyond recession and into a depression” and that “the inevitable crash we're experiencing is a result of the worst liquidity and banking meltdown this country has ever seen.” Many investors panic and immediately flee the market thinking cash, treasuries, and bonds are the safer bet until they can figure out what the market is going to do.

As a result, Google's stock price plummets by 4.12%. $5.7 Billion in Google shareholder value (market capitalization) is lost in a single day. Wait a minute Google is a global company, not just a US company and they're not even in the financial sector, right? Right. And Google continues to post strong earnings, great growth and is dominating their competitors in market share and revenue growth, right? Right. Google still has the same solid management in place and isn't in any sort of financial, litigation, or other major trouble either, right? Right. So what the #^% happened? In short, investor psychology. When people panic you see a lot of short term fluctuation in share prices as a result of their behavior.

3/18/08 One day later:
The Federal Reserve Bank holds its monthly meeting and slashes interest rates by 75 basis points. They calm fears by reminding people that inflation is in check, promise to keep pumping cash in to ease the liquidity crunch, and demonstrate again that they are willing to do whatever is necessary to stabilize the economy and avoid a prolonged recession.

Professional analysts and news pundits are clamoring again but this time they tell us that the Fed is making some brilliant moves. “They have revived measures not used since the great depression, pumped over $200Billion dollars into the system to ease liquidity, and gone on the most aggressive rate cutting spree we've seen since the early 1980s banking crisis.” They assure us that the Fed has done so much that we are going to see strong price action in the coming weeks and months and are likely to avoid a recession. The same investors that panicked yesterday panic again, but this time they are flooding back into the market for fear of missing out on a big rally (which they ironically create).

Only one day later, Google's stock price soars by 4.59%. $6 Billion in Google shareholder value is created in a single day. Do you think Google's true value really changed so drastically in a two day period? Of course not. There is simply a lot of volatility in the short term, which is why we want you to understand a little about investor psychology, so you can avoid the herd.

In the example, the herd sold on the way down and bought on the way up. If you buy high and sell low you are guaranteed to lose money. Unfortunately we are programmed to act this way, your mind will try to get you to make stupid stock market moves whenever you are scared or stressed, you'll have to make a conscious effort to avoid these mistakes. Warren Buffet once said “simply attempt to be fearful when others are greedy and to be greedy when others are fearful” and we think that is brilliant advice.

To avoid all of this unnecessary stress, master your own psychological impulses. Hold on to your winners for as long as you can, at least a year, and don't let short-term market volatility scare you into or out of the market. Why? Long term investors win, short term investors lose, and that's not a theory, it's a fact. Also, avoid bouncing between strategies when the market changes, reacting to news, or trying to time the market by moving back and forth from cash to stocks. If you understand your strategy and are good at implementing it, you should wind up with high quality stocks that you bought at a good price and that you can hold onto for a long period of time.

Dollar Cost Averaging

Dollar Cost Averaging means investing a fixed amount of money on a regular basis. For example, if you invest $300 every month regardless of market conditions, you are dollar-cost averaging. The benefit is that you are always buying more stock when prices are low since the market trend is usually upward. The reason this is so important for you to learn is because most investors do the exact opposite. Don't you feel the urge to buy when the market is bullish and rising and feel the urge to wait or sell when the market is bearish and dropping? Most people do, and as a result they buy when prices are high and do nothing or sell when prices are low or falling. This kind of behavior greatly increases your cost basis and decreases your returns, so avoid it, be a dollar-cost averager.

This is easier to understand with an example:

• Dollar-Cost Averaging: Let's say you decide to buy $300 worth of an S&P 500 index fund per month for three months regardless of market conditions. In the first month the price is $12 so you receive 25 shares, in the second month the price is $15 so you receive 20 shares, and in the third month the price is down to $10 so you receive 30 shares. Your average cost per share is $12 ($900 invested / 75 shares owned), you bought the most at a lower price. When the index goes back to $15, you have your $900 investment plus a $225 profit for a total of $1,125.
• Typical Investor Behavior: Now we'll look at how most investors behave. You loved the index fund at $12 so you bought the same 25 shares as the dollar-cost averager, and you loved it even more at a bullish $15 so you bought the additional 20 shares. Unfortunately, when it dropped to $10, you got nervous and decided it would be best to wait and see what happens before you sink any more money into the market. Your average cost per share is $13.33 ($600 invested / 45 shares). When the index goes back to $15, you have your $900 investment plus a $75 profit for a total of $975.

The dollar-cost average earned a 25% return while the other investor only earned 8%. Remember that even if the market tanks it always recovers for long term investors, and when it is low you will snatch up a lot of shares at bargain prices. As long as you are dollar-cost averaging you will always be buying shares at a cheaper price.

Hold On To Your Winners and Sell Your Losers

While this is actually a component of investor psychology, it's important enough to have earned spot #9 on our top 10 list of investing principles.

Sounds silly doesn't it, why would any investor hold on to their losers and sell their winners? Oddly, this is what many people do, and not just beginners. Even seasoned investors will fall into this habit occasionally if they're not diligent about sticking to their strategy.

Let's first talk about holding on to losers, almost everyone has done this so it's an easier concept to absorb. We often put a lot of hard work into selecting investments. By the time we finally hit the “Buy” button we are confident that we've made a wise and profitable choice. However, investing is a numbers game, we can't be right every time and we will inevitably pick losers now and then.

When this happens, rather than realizing that we either missed something when we did our research or that something has fundamentally changed about the company or the market, many of us still stubbornly believe that we made a good investment. Because we worked so hard to identify a good stock, we find it hard to believe that we were wrong. Even if the price is dropping while our other investments are going up we hold onto it because we're sure the loss is only a temporary correction and that the stock will head back up very soon.

This behavior is frequently referred to as “falling in love” with a stock. We can't bear to part with a “good” stock and taking losses is psychologically painful so we wind up riding our losers down. This rarely ends well. Eventually we realize that no recovery is in sight and we sell the stock back into the market at a much larger loss than we should have taken.

On the other side of the equation, when we review our portfolio and see that an investment has done particularly well, we are often tempted to take a profit because we don't think that any company can sustain such exceptional performance for long. Stock investors are more likely to behave this way than fund investors since they are looking at individual stocks but it can happen to anyone.

Let's look at Google again since it's a company we've already used for several examples. The company's IPO occurred in August 2004 and many of the early investors bought in for between $90 and $110. By April of the following year the stock was already trading at about $180 but the stock price had been flat for several months and appeared to have hit resistance. As a result, there was an enormous amount of selling volume in April. Had Google's growth potential or business environment changed? No, the selling was simply early profit-taking by skittish investors. Four months later on the one-year anniversary the stock was trading at $300. By the third anniversary in 2007, the stock was trading for $510. Ouch, painful lesson.

As painful as it is to take a loss, smart investors set sell limits for every investment that they buy. If it gets close to that limit, they reevaluate to see if they erred in their research or if something has fundamentally changed. Regardless of the situation, if the investment hits the sell limit, they get rid of it, they don't ever hold on hoping it will go up because they know their money will be better off working for them elsewhere.

On the other side of the equation side, avoid selling winners by doing as much homework before you sell as you did before you bought. If the company still meets all of the criteria for your strategy, isn't it still a winner and shouldn't you hold onto it? Trust your strategy and hold onto any investment that still meets all of your buy criteria, there is no limit to how high a stock can go so price appreciation should get you excited, not scare you to the sidelines.

Don't throw good money after bad. If you hold onto losers or sell winners, you are not managing your money efficiently and this will kill your returns. The easiest way to correct this behavior is to stay objective with every investing decision and stick to your strategy, never let your emotions make investing decisions for you.

Keep it Simple

This is so true about everything in life and it's especially true about investing. As a beginner, you are probably overwhelmed by the amount of information you need to learn to become a savvy investor. This is a good time to point out an important fact. Your confusion is a result of your lack of knowledge and from the overwhelming amount of new information being thrown at you, NOT because investing is complex and sophisticated.

Don't stray from the keep it simple philosophy as you become a more seasoned investor. Einstein said that “everything should be made as simple as possible, but no simpler” and that's great advice. You have to understand the basics of your strategy, but don't needlessly add complexity because you feel being a more sophisticated investor will make you more successful.

In the Index Fund and ETF Investing Guide and it is a great example of the Keep it Simple philosophy. Index investors choose funds that own the stocks of whatever index they'd like to track That's it, that's the whole strategy. You were expecting more? Don't let that fool you into thinking it is weaker than more complex strategies, Index Investors beat over 75% of all professional fund managers and analysts. Half of our Fund Street Monthly newsletter is dedicated to Index and ETF investing because it is one of the best strategies even though it is also one of the simplest. Bottom line, if you adhere to the 10 Basic Principles of Investing, always continue to learn, implement your strategy well, and stay abreast of changes in the market and the economy you will be a successful investor.

Invest in What You Know

Have you heard of Peter Lynch? The guy who took over the $18 million Magellan Fund in 1977 that grew to more than $14Billion in assets by the time he retired only thirteen years later in 1990. Peter advises beginners to “invest in what you know”, and his message still resonates with working people who don't have the time to learn complicated technical analysis or read financial reports as thick as a phone book.

Invest in what you know. Sounds simple but there is a lot of wisdom in this advice. Lynch meant that in our everyday lives we tend to become experts in some field or another either because it relates to our career or because we use related products on a daily basis. For example, if you have been a pharmaceutical salesman for the past 15 years, you probably have picked up a lot of knowledge about the major companies, the industry, how a product is tested and marketed, not to mention detailed knowledge on any drugs that you have sold during your career. This expertise is your foundation and gold mine as an investor.

To emphasize this point, imagine you are the pharmaceutical rep described above and you are trying to decide between two different investments.

The first is a profitable and established pharmaceutical company that you've been competing against for 15 years. Your friends think it's a boring stock and point out that their share price hasn't budged in five years while the market has made great gains. They tell you that new drugs come out all the time, and remind you that this company has already released two this year without making any impression on investors or impact to the share price.

However, you know that this pharmaceutical company has solid patents and recently received FDA approval for a cheaper generic version of a very expensive drug that your company makes. Sales for your company's competing drug have plummeted as a result. You also know that this is a popular drug, many doctors will prescribe it to the elderly on a regular basis. You ask around different companies and reps in your industry and find that no one else has anything in testing or pending approval that can compete on a cost basis. Finally, this company is huge, they will have no trouble digging into their deep pockets to market and mass produce.

The second potential investment is a tech IPO that your broker and a couple of your friends are really excited about. Apparently they invented some type of technology that can improve the speed of all search engines and they just landed Google as a client, the major player in the search engine space. As a result of the Google deal, they are already making money which isn't always the case for many startup tech companies. You're seeing a lot of news about this IPO, it looks like it will be a hot stock since there's already so much buzz. Your broker even offered to get you some IPO shares which will probably net you a nice profit on the very first day of trading.

What would Peter Lynch do? He would buy the pharmaceutical company every single time. Here's what you know. The well-established pharmaceutical company has a new patent protected drug that is already approved for sale by the FDA. The tech company has an unproven product, investors don't even know if major search engines such as their new client, Google, will need or continue to use the technology. The drug is already proving itself by outselling you, the competition. You have no idea how well the tech company is equipped to compete and it sounds like they may be dependent on their one major client for survival, Google. Not a strong position. Finally, there won't be any competitors for several years for the drug company because no one is even testing a competing product yet. What are the barriers to entry for the tech company, could one pop up tomorrow or could Google or Yahoo just make their own version of the technology?

We certainly don't want you to get the impression that you should avoid every strategy, stock, or fund that you don't know much about. What we really want you to understand is that you should play to your strengths when you invest. Invest in what you know when you can and when you want to try something new, take the time to learn a lot about it first.

Ignoring this rule can ruin even great strategies. For example, a value investor is always looking for great bargains, i.e. underpriced stocks. But if they buy companies that they know little about, more often than not they'll wind up with a stock that has done something to deserve a low share price and would have been best avoided. There is an enormous amount of information available for any stock you'd like to buy. Study the company, their competition, the industry, and anything else you can think of before you decide. This sounds like a lot of work but your portfolio will reward you generously in the form of profits if you do your homework.

Compare Investment Performance Against An Appropriate Benchmark

One of the most common and costly mistakes that new investors make is not measuring their performance against an appropriate benchmark. Many don't compare to ANY benchmark, much less an appropriate one. What is the danger? The biggest drawback is you will never really know how well or poorly you are investing.

A stock-tracking index such as the S&P 500 is the most common type of benchmark. There are tons of them, they are easy to look up, and there are plenty of free tools available that will allow you to compare your performance to an index with just a couple of mouse clicks. We will provide a list of the most popular and which strategy they match in the chart below.

Here's an example to put this concept into context:

The year is 2003 and all of your money is invested in Large Cap US companies. Your total portfolio increases by 14% for the year. Pretty strong, right? The problem is that you have absolutely no basis of comparison. Now let's add some information and see how drastically it can change the picture.

The S&P 500 Index contains 500 large cap companies, so it is the perfect benchmark to use for this example. In our example, you gained 14% for the year but the actual S&P return for 2003 was more than double at 28.68%. To add insult to injury, let's also throw in the possibility that your returns are much less because you selected highly volatile companies and a few tanked. This means that not only did you trail the S&P returns dramatically, but you are also likely to lose money faster than the S&P 500 when the market turns bearish since you have a higher risk portfolio.

Regardless of your strategy or goals, you should always compare your month-over-month and annual performance to an appropriate benchmark. We already mentioned that if you don't compare you'll never know if you're improving as an investor. Another major reason is to see how well you are implementing your investing strategy.

For example, if you've chosen to purchase large growth stocks and technology stocks a good index to compare too would be the NASDAQ 100. If you outperform the index for several years in a row, then you have proven that you are good at implementing your strategy of buying high potential growth and technology stocks. However, if you are underperforming the index, you either need to study your strategy more or just buy an Index Fund or ETF that tracks the NASDAQ 100.

Unfortunately, many people think that buying an index fund is like throwing in the towel. They feel this way because it means accepting the market returns, index investors aren't really implementing any traditional investment strategy. However, here's a little secret to keep in mind; index investors beat over 75% of investing professionals and an even higher percentage of individual investors. If you want to learn more about Index Investing, read our Complete Guide to Index Investing or our Index Investing Review (Index Funds & ETFs). If you can't beat 'em, join 'em.

Most beginning investors feel intimidated when they hear index names like the S&P 500, Dow Jones, or Nikkei so here's an alphabetically index list to help you figure out which index to use. The question we get the most is “what if I have several types of investments or if I am trying more than one strategy?”. No problem. That means you'll look at more than one index and you should compare each investment or group of investments to their relevant index.

Major Index Reference Chart

You probably noticed that there is a lot of overlap. You don't have to choose the perfect index, you can either select the most popular or select several, just make sure you choose indexes that are relevant. For example, if you're buying Blue Chip stocks, you should definitely look at the Dow Jones Industrial Average but you may also want to occasionally compare against the S&P 500 since it is a similar large cap indexes.

Manage Your Investing Expenses

Expenses can quickly eat into your earnings, especially if your portfolio is still relatively small. There are many types of expenses but the most dangerous to your portfolio are transaction costs, taxes, and investing information costs.

Transaction costs come in many forms but they all chip away at your returns, especially if your average transaction is small. This is how regular and online brokerages make money, they charge you when you buy and sell stocks, bonds or mutual funds.

These fees vary greatly, but one important piece of information we can share with confidence is that it is much more expensive doing business with a brick and mortar financial planner or broker. They usually charge $35 or more per trade regardless of what type of investment you buy. In addition, planners will charge you for various services or by the hour, depending on the planner, and that can run into the thousands. They also tend to push the funds that pay them the biggest commissions. Beware the planner that ever pushes a fund loaded with fees and expenses, there's no reason to pay them now that you can trade them online for free (see the Mutual Funds Basics guide to learn more about No-Load Funds).

In contrast, the typical online trade is around $9.99 for stocks and most funds trade for free. Brick and mortar brokers and planners justify their much higher transaction fees by saying you are paying for their expertise, not just the transaction. Not many earn that extra money in our opinion. Great investment advice is pretty cheap nowadays, some of the best investors in the world provide investment advisory services that cost less than $200 per year. There are always exceptions, so if your local planner is great, keeps fees low and outperforms the market, by all means, stick with him. While $9.99 online trades are much cheaper, they can still add up. Take our advice and keep track of all your fees, avoid local brokers and planners, and buy and hold as long as possible unless you've picked up a real dog.

Taxes are another large expense for those of us with portfolios in a taxable account. Obviously our first piece of advice is to stick every penny you can into tax deferred accounts (read the 401K guide and the IRA and Roth IRA guide to learn more about tax deferred accounts). This will allow your money to grow tax-free until you retire which will save you a fortune in tax expenses. For those of us that can't put all of our savings into tax deferred accounts, the best way to keep your tax expense low is to hold your investments for as long as possible. Why? If you hold an investment for at least one year before you sell, you only have to pay the long term capital gains tax on the profit which is 15% for most of us and 5% in the lowest tax brackets. If you don't hold your investment for at least a year, you will pay your normal tax rate which can be as high as 35%. Long story short, buy and hold.

Our last category, investing advice expenses, consists of the price you pay for whatever type of investing advice you buy each year. It can consist of financial planning, website subscriptions, monthly investing newsletters, investing classes, and magazines subscriptions to name a few. We can't imagine how you would ever need to spend more than $1,000 per year to get great information. Even less if you are a beginner and your portfolio is still small because these expenses cut into a much larger % of your profit.

Of all the different types of investing costs, investing advice expenses are the easiest to manage if you do a little research before you buy. Check out this article for a few tips to manage investment expenses.