5 Rules of Successful Stock Investing

5 rules of successful stock investing. Has it ever happened to you that despite all the efforts, taking utmost care in picking stocks and careful analysis, you have still lost money in the market? If you listen to Pat Dorsey, Founder of Morningstar, it’s mostly because you have not followed the rules of successful stock investing that are crucial for investment success.

Pat Dorsey in his book 5 rules of successful stock investing says that if you do your homework, stay patient, and insulate yourself from popular opinion, you are likely to do well. It is when you get frustrated, move outside your circle of competence, and start deviating from your personal investment philosophy, is that you are likely to get into trouble.

According to Pat Dorsey, these are the five rules of successful stock investing that you must follow:

Do your homework:

This sounds very obvious but is rarely practised in reality. The most common mistake investor makes is failing to thoroughly investigate the fundamental of the stock they are going to purchase. If you do not know the business inside out, you should not even think about investing in it.

You need to develop some basic understanding of accounting so that you can analyse for yourself what kind of financial shape the company is in. You have to understand that it’s your money that is at stake and you cannot take someone else’s word that a company is an attractive investment, so you should know what you are buying.

Once you have learned the basic accounting tools the next step would be to put them to use, which means to sit down and do the number crunching, reading the financial statements, annual report and even comparing it with the peers of the industry.

This does look like a lot of hard work, and if you are pressed against time, its even more difficult, but if you take out time to thoroughly analyse the company, it will help you avoid many poor investments.

Now there is a popular argument given that what if I miss a big move in a good stock while researching it? I am not denying the fact that your research might take a long time and you may miss a rally or two, however, missing out on few upsides will not make a big difference in the overall performance of your portfolio, in fact it’s a necessary step to avoid some investment that looked attractive in the beginning but turn out to be poor ones later.

Find economic moats:

The word moat was used in medieval times for a huge water body surrounding a castle to defend it from invaders. Economic moat is one of the cornerstone concepts of value investing. The term economic moat is used to describe a firm’s competitive advantage over its peers, which helps a business from being taken over by the competitors.

In any economy, capital seeks area of highest expected returns. As a result, the most profitable firms find themselves competing against many of their peers trying to take over the highest market share.

Economic moats allow smaller companies to retain their market share and above average levels of profitability for many years, making them most superior long term investments.

The key to identifying a wider economic moat is to find the answer to a simple questions such as how does a company manage to keep its competitors away and consistently earn higher profits? Find an answer to this question and you have found a source of strong economic moat.

There are many ways a company can create economic moat, I have written a detailed post on 5 ways a company can create economic moat.

Suggested Read: 5 ways companies can create economic moat

Margin of safety:

This is by far the most important rule among all the five rules of successful stock investing.

Finding a great business is just one part of successful stock investing, the other part is assessing the true worth of the company.

Benjamin Graham in his book “The Intelligent Investor” said “if you pay too high price for a great business, it’s still a poor investment”. You cannot just pay whatever the market is asking for the stock because market might be demanding too high a price and if the price you pay is too high your investment returns are likely to be less fruitful or even disappointing.

So what is margin of safety? Warren Buffet explained margin of safety in a very simple manner”, here is what he says:

“You don’t try to buy a business that is worth $83 million for $80 million, you leave yourself an enormous margin in case you are wrong, if you drive a truck across a bridge that says it holds 10,000 pounds and you have got 9,800 pound vehicle, it’s not a wise decision to do so as the margin for error is very thin.”

The goal of an investor is to buy stock for less than what they are really worth, the margin of safety in case of investing is the difference between the present value of the business, how much it’s going to be worth in the future and paying lot less than that.

The reason why margin of safety is important is because if you later realized that you overestimated the company’s future prospects, you will have a built-in cushion that will mitigate your investment losses.

But how much margin of safety should you maintain, well the answer to that is very subjective and depends on how predictable the future earnings of the business is.

Once again, Warren Buffett explains it very clearly, “If you understood the business perfectly and the future of the business, you would need very little in the way of margin of safety, the more a vulnerable a business is, assuming you still want to invest in it, you need a larger margin of safety.”

In simple words, the size of your margin of safety should be larger for shakier firms with uncertain future, and smaller for solid forms with reasonably predictable future.

Hold for long haul:

Every investor must remember that a stock is not just a ticker blinking on the screen, every stock has a business behind it, and when you buy a stock, you buy a part ownership in the company. Thus every stock purchase should be treated as seriously as buying an entire business. Investing is a long term game since every company needs some time to grow, you have to be patient.

Trading stocks frequently can be very injurious to your health and wealth. When you trade frequently, the cost of trading begins to add up both in terms of brokerage and taxes, and creates an insurmountable hurdle to good performance.

There are many reasons why one should trading stock and invest for long term, I have written a detailed post on some of the most important reasons why you should invest for long term:

Suggested Read: 7 Reasons Why You Should Invest for Long Term

Pat Dorsey in his book 5 Rules of successful stock investing has used a very interesting hypothetical example of Trader Tim and Long term Lucy to explain how long term investment is better than trading stocks. He says:

“Let us look at two hypothetical investors to see what commissions, trading and taxes can do to your portfolio.

Long term Lucy is an old fashioned investor who likes to buy just few stocks and hang on to them for a long time. Trader Tim is a one who likes to get out of stocks as soon as he has made a few bucks.

Now, Lucy invests $10,000 in 5 stocks for the next 30 years at a 9% rate of return, and when she sells her investment she pays 15% tax as long term capital gains.

Tim on the other hand invests the same amount of money at the same rate of return but trades the entire portfolio twice a year, paying 35% short term capital gains tax of profit an re-investing what is left.

After 30 years Lucy will have about $114,000 while Tim has less than half the amount only about 5$4,000. Remember, for the sake of simplicity, we have not calculated any brokerage they had to pay on each transaction. Things will look even worse if we include commissions charged for each transaction.

As you can see, letting the money compound over a long period of time makes a huge difference. The cost of taxes and commission can take a big bite out of your portfolio that is the reason why it is always beneficial to hold stocks for long haul.”

Know when to sell:

A lot has been said about when is the right time to buy a stock, but very little is said about when is the right time to sell a stock.

Although one should not sell any stock as long as the fundamentals of the company are intact, there are times when you feel that the investment you made may not last forever and at some point it becomes necessary to exit that stock.

Knowing when it’s appropriate to bail out of a stock is as important as knowing when to buy one. The key is constantly monitor the companies you own and analyse the fundamentals rather than checking their price on a daily basis.

Here are the five questions that you should ask yourself while selling a stock:

Have the fundamentals deteriorated?

One of the reasons why you should sell a stock is because the company is no longer able to perform well, especially because the fundamentals of the company are deteriorating.

This usually happens when the economics of the sector in which the company is working are no longer favourable for the business of if intense competition takes away the durable competitive advantage of the company. In both the cases, the investor must become cautious.

Suggested Read: 5 Signs that show a company is declining

Some of the sure signs of deteriorating fundamentals of the company are if the growth of the company has started to slow down for past many years, if the cash is piling up and company is unable to find profitable ventures for new investment opportunities, shows that it’s time to re-assess the company’s future prospects.

Has the Stock risen way beyond its intrinsic value?

Warren Buffett says “Our favourite holding period is forever” which means that if a company is doing great, you should keep holding it forever. However, there are times when markets wake up in a very good mood and offer insanely high prices for all the stocks.

While this is the time most investors get greedy, thinking the price will continue to move in one direction, what they often forget is a simple rule of “Regression to means” which simply states that if a stock becomes really expensive compared to its intrinsic value, you can expect it to correct soon.

Even the greatest companies sometimes reach a valuation where it is no longer a wise decision to keep holding them, no matter how great the business is, it should be sold if its trading at egregious price.

Are you overexposed to a single stock?

The key to smart investment decision is not to let emotions like greed and fear come in the way of decision making.

If you feel that you have invested too much in a single stock or a fund and such exposure worries you, it time to think long and hard about trimming down no matter how solid the company’s prospects may look.  

As the saying goes “Never put all your eggs in one basket”

Summary:

Before we wrap up, here is a quick summary of whatever we have learned in this post:

A successful investor follows personal discipline and does not bother whether the crowd agrees with him or not. That is why it is crucial to have a well-grounded philosophy.

Unless you understand the business of the company inside out, you should not even think about buying the stock.

While looking for great investment, focus on companies with wide economic moat that can help keep competitors at bay.

Do not buy stocks without margin of safety, sticking to principle of value investing will help you avoid making irrational decisions, blow-ups and will improve your investment performance.

Always invest for long term and avoid trading stocks because costs of frequent trading can be a huge drag on performance over time. Treat every stock as buying the entire business, this gives you an owner’s perspective on your stock thus your focus is more on the financial performance of the stock rather than price movement.

Don’t sell a stock just because you have made decent profits or it has incurred some losses in the short term. Just be patient and give it some time to grow. If the stock’s fundamentals start deteriorating or if the stock has become too expensive compared to the underlying value of the business, then it’s time to sell the stock.