With a mindset of a long-term investor, I buy stocks with the goal of keeping them forever. In other words, I am not looking to make a quick buck from frequent ups and downs of the market; nor does it bother me if one of my stocks has nose dived due to some temporary or short term situation.
This allows me to make my investment decisions based on long term goals of building wealth and generating sustainable and growing income while ignoring day to day gyrations in the stock market.
The strategy does require lot of patience and tenacity to stay the course; it is especially true when market is going through a correction or even worse a recession. Therefore, whenever I am feeling impatient or having the urge to make a buy/sell decision in a hurry, I would simply review my investment principles. That will put me back on track and prevent me from making a bad decision.
I have a set of principles that I follow when investing in stock market. It is part of my business plan for investing in stock market. These principles help me stay on track and discourage me from drifting into areas that are outside of my circle of investment competency besides ensuring that I have done due diligence before hitting the 'buy' or 'sell' button.
Here are my investment principles:
1. Do homework before buying a stock
2. Buy a stock only as a long term investment
3. Only buy dividend paying stocks
4. Don’t fall in love with a stock or company
5. Diversify across industries, sectors, and geographies
Principle 1: Do homework before buying a stock
Doing homework means studying company’s financials and stock fundamentals to gauge whether the company is financially sound and has potential for future growth and good investment returns. It will also help determine the fair value or the price that is reasonable for the stock. Buying at fair price will ensure that I am not overpaying for the stock. It will also ensure a decent margin of safety.
All the information needed to make a sound decision to whether invest in a stock/company is readily available on the internet for free or at minimal cost from either company’s own website or through various financial websites such as Google Finance, Yahoo Finance, and Morning Star. Therefore, there is no excuse to not do due diligence before investing in an individual stock.
Just as with anything in life, it takes time and effort to do it right. Overtime you will develop a mental model that will allow you to quickly scan through company's data and see whether it fits that model or not. You will discover certain tools that will allow you to look a the data in a visual manner that is easier to comprehend than a spreadsheet of numbers. In my later blog posts, I will cover some of these strategies and tools.
Principle 2: Buy a stock only as a long term investment
My second investing principle has to do with buying and holding a stock as a long term investment. From US tax code perspective, a long term investment means that you hold a stock for at least one year. For me, the long term means as long as the company’s fundamentals hold while still providing an annual return (including dividends) of at least 3% or higher.
I look at the stock buying process as buying a business that will generate growing returns for years to come while providing current and future income.
Principle 3: Only buy dividend paying stocks
I only buy stocks in companies that pay regular and growing dividends. There is no exception to this rule. I have been following this rule for almost seven years now and it has done wonders for my stock portfolio. Not only I have been able to beat the overall market by a wide margin, I have also created a passive income machine that has allowed me to retire early from my day job.
Dividends are normally payed from company's free cash flow and require that company maintain and grow it's operating and free cash flow while keeping the cost under control. This ensures that management is growing business while maintaining a sound balance sheet. Also unlike earnings which can be engineered to look good by the management, it's very difficult to engineer or fake the cash flow.
A company with a long term history of paying and growing dividends shows that its management is shareholder friendly and focused on growing its business.
I should warn though that not all dividends are equal. In other words, some companies may take debt or do massive cuts in their business spending (CapEx) to pay dividends to the shareholders. In some cases, it may be justified while in others it could be a sign of trouble or business in decline. Therefore, it's important to do due diligence in understanding the source of dividend rather than just buying a stock because it pays a nice dividend.
Principle 4: Don’t fall in love with a stock
We all have our favorite stocks when it comes to investing in stock market. Many times the favorite stock is simply the stock of a company that we work for and love. Other times, it could be a stock that has made us lot of money over the years and we believe that it would continue to do so in the future even though there may be signs of slow growth or even decline.
Even good companies do get out of favor and sometimes go bankrupt after decades of being successful and staying on top of their industry. Industries and trends change over time and require companies to adapt to new changes and sometimes even reinvent. Companies that fail to see such changes or too slow to adapt end up becoming instinct. Examples of famous companies that failed to adapt and became instinct or are in decline include Eastman Kodak, Digital, Blockbusters, Blackberry, and Yahoo.
Point being, just because a company has done well and has been on top of their business in the past doesn't mean they will continue to be on the top of their industry in the future. Therefore, as an investor it is important to keep an eye on the future growth prospects of a company and periodically evaluate whether the company is keeping up with new market trends and overcoming disruptions due to new competitors or new technologies.
Also I like to avoid being overweight in any one stock or industry sector. I know first hand that it is really easy to accumulate lot of stock in a company that one works for. This is due to stock grants and stock purchase discounts that companies give out to their employees. Some people don't sell any of this stock because they believe in the company they work for or may see selling as an act of disloyalty to their company or they may be simply in denial.
Even worse, I have seen friends buy company stock in their retirement accounts. If something happens to the company and they get laid off, not only they will lose their jobs but they will likely also suffer a big loss in their retirement accounts. This could be devastating as the lost value could be a large sum since most retirement accounts such as 401K are based on automatic paycheck contributions spanning over the entire duration of employee's service.
It is therefore important to be objective when assessing future growth prospects and determining whether it makes sense to keep holding the stock despite of whatever emotional attachment you may have with the company. Also, I like to set a limit of 10% for each stock in my portfolio to ensure no one position becomes overweight.
Principle 5: Diversify across industries, sectors, and geographies
I like to diversify my investments across 40 to 50 individual stocks or companies spread across 10 sectors of S&P 500. I mainly invest in individual US stocks. Though, I have a small position in foreign stocks in the form of ETFs and Mutual Funds. I use ETFs and Mutual Funds for foreign stock investment mainly to compensate for the higher risk of investing in foreign markets which don't have the same level of SEC (Security & Exchange Commission) regulations as US stocks and companies.
ETFs and Mutual Funds provide instant diversification as they are simply a basket of stocks that are put together in a single fund by an investment firm to follow a certain investment strategy or a index (i.e. benchmark). For example, if I just want to invest in US stock market and not trying to beat the market then I can buy shares in any of the S&P 500 ETF low cost Index funds such as the popular SPY, VOO, and IVV. They are a good option for anyone who is looking to invest in US stock market but does not have time or passion to do their own stock picking and portfolio management.
Even if you have done all the due diligence and have hand picked the best of the best stocks, there is still no guarantee that something wouldn't go wrong with your investment. Therefore, if you put all your money in a single stock or even a single sector, you are taking a huge risk and essentially gambling with your money.
It is extremely important to diversify and this is one of the ways I manage risk in my portfolio by spreading out investments across many stocks and sectors and possibly geographies.
What investment principles do you follow and how diversified are you?
Disclaimer: Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. This article is for informational purpose only. Please use your own judgment or seek a licensed financial advisor before investing. You, the reader, bear responsibility for your own investment and financial decisions.