The 4 Most Important Rules of Stock Market Investing
In this article, I want to share with you the four most important rules for investing according to legendary investor Phil Town. In investing there are a few steadfast rules that should always be followed more than suggestions or like pirate rules guidelines.
These rules are designed to keep people from making poor investments and they apply in virtually every investing scenario. These are the rules that even the world’s most successful investors still follow to a T and they’re even more important for investors who are just beginning to stick to.
1. Understand the Difference Between PRICE & VALUE
Price and value are not necessarily the same thing. For example, if a person is selling gold bars for $5 apiece, that does not make the value of those gold bars $5 they might be priced at $5.
Their value might be much higher or lower, depending on the size, weight and purity.
Sometimes the market is equally as irrational in the way it prices certain companies as those gold bars. There will be times when a company’s price is well above its value and there’s going to be times when the company’s price well below its value and these are just the normal fluctuations of the market and we use those as an entry point and an exit point of our investing.
The point is you just can’t go off of whatever the market’s pricing the company or asset at and assume that’s what it’s worth even though that’s exactly what the way most investors who were running money in this country actually do.
They just say, oh, that’s the price, that’s the value. Good investors on the other hand understand the difference between price and value and because they understand there’s a difference, then what they’re doing is waiting in cash for an opportunity when the price of a company they understand is well below its value.
Now, they also know how to avoid companies that they understand when they are priced well above their value. So it doesn’t matter that you love the business, you understand the business. If you are paying way too much, that’s crazy and you’ll never go to be a great investor.
To calculate the value of a company rather than just looking at its price, what I’m going to recommend is that you go use the margin of safety calculator you can find at, www.ruleoneinvesting.com. If it turns out that the market has put a great company on sale, then you have an excellent buying opportunity.
2. Always Stay Rational
Emotion is the enemy of smart investing. Sometimes when people see a company soaring in price, they get excited and they get greedy and they want to buy into the company because they think it’s just going to keep going up when the price is already at an all-time high.
In fact, their entire investment strategy is based on buying just the companies that are at an all-time high. Other times when the price of a company drops fear is causing people to sell. These emotions and the response they cause lead far too many investors to buy high and sell low, which is exactly the opposite of what you should be doing.
So staying rational in the face of price fluctuations kind of goes back to our first rule; Understanding the difference between Price and Value. If you can keep in mind that the price of a company is kind of arbitrary, and is determined by both emotional and savvy investors in the market. This combination of people ultimately is setting the price in the market.
Ultimately, it is the true value of the company that matters and if you can keep that distinction clear, you’re going to be a lot less likely to panic when the price drops and a lot less likely to get crazy greedy just because it’s going up.
As investors, we like to stay rational and just buy the fear and sell the greed, not the other way around.
3. Always Buy Companies on Sale
You cannot possibly get high rates of return with low risk. If what you’re doing is buying everything in the market at whatever price they’re selling it for. Mr Market is manic-depressive.
Some days he’s manic and then there’s never going to be a time when the market goes down and he’s always willing to pay more for the company. And other days he gets so depressed, it’s like the sun’s never going to come up in the morning.
What we want to do is buy when he’s depressed and sell when he’s manic, but when there’s fear and sell when there’s greed, investing is just like any other business.
You must buy at a discount if you hope to turn around and sell it for a profit. Just remember this “You make money when you buy, not when you sell”.
In any business, if you keep paying retail, if you’re in the retail business, you’re never going to make any money. If you pay a price, that is equal to the company’s value, you have no room to benefit from the market emotion.
If you pay a price, that is more than the company’s value. You’re going to end up just killing your overall rate of return. Now, thankfully the market is not 100% rational and it frequently puts great companies on sale. Because guess what? There’s a herd instinct out there like nothing you have ever seen among most of these big fund managers. Thousands of them, they run in one direction, it’s almost like lemmings, they all got to go.
Many times there may be a bit of bad news that doesn’t affect the value of a company. What it does is scare big managers enough to drive the price down. Why would they get scared? Because they’re judged in their performance based on quarter to quarter success and if their competitors are selling off that company, man, it’s terrifying. These guys are going to get stuck, lose money and get fired. So if you can stay rational in the face of this kind of fear being driven by short-term results from investment fund managers, you’re going to find some great buying opportunities. History has proven this investment truth, over and over again.
If a company isn’t on sale enough to offer a good margin of safety, just put it on a wish list. If you love the business, put it on a wish list and wait for it to go on sale. And then meanwhile go look for another great company and find one that maybe is priced correctly with a margin of safety.
4. Only Buy Stock of Companies that You Understand
This investment strategy is so important. This is the most important thing I can share with you, you are not going to be successful as an investor if you buy things you don’t understand.
Making wise investments requires that you fully understand the company you’re investing in and this includes knowing and believing in its management, understanding the company’s mission. Does it match your values?
Understanding where it’s been, its history, the challenges, competitors, etc. should give you a level of confidence that emotional investors never consider.
There’s a lot there that you need to learn about. Just like if you were going to buy the house next door and rent it out, you would know the location. You would know why people are moving into the neighborhood, not moving out. You would know what the right values are for the company and without knowing those things, you’re just gambling. You don’t know what price to pay for that thing and that’s the same thing with companies.
You don’t know what price to pay if you don’t understand the business. And if you don’t do that, if you don’t understand clearly you’re not going to make money investing. Investing will be gambling for you, not investing.
Now before investing in a company, one more thing… Always take time to thoroughly research everything you can about it.
Just keep asking yourself what can go wrong? What don’t I know? What don’t I know? The more you know about the company, the better informed your choices will be. If for whatever reason a company is too far outside your wheelhouse for you to completely understand it, it’s better to put your money elsewhere like in the bank and if this is too hard for you, then you’re looking at too many kinds of companies.
Look at just companies that are right in your wheelhouse and stay within that wheelhouse. Stay within that circle of competence. Otherwise, you’re better off just buying an index and spread your money across 500 companies and not worrying about trying to get a great return in the market.
Now, as always we love to hear from our readers over on our FACEBOOK PAGE. Do you have any unbreakable investing rules that you follow? Leave a comment with your answer and we will be sure to follow up with you. And thanks for reading this article, now you guys & gals go play.
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