In this article, I will discuss the 10 crucial investment principles you need to have as a stock market investor. By the end of this article, you will have gained a broader understanding of the stock market and will be able to apply this knowledge to improve your long-term returns.
Through looking at what the majority of people are doing that results in them falling short with their stock market investments, you'll be able to avoid these roadblocks and shorten the learning curve associated with becoming a successful investor. So, ensure that you understand and apply each of the 10 basic stock market principles to improve your chances of success in the stock market.
Principle #1: Capital Appreciation and Dividends
Surprisingly, the first principle many investors do not understand is how money is made through the stock market. This is through capital appreciation and dividends.
Capital Appreciation
The primary way money is made in the stock market is through capital appreciation. Essentially, this is buying low and selling high on the stock market.
Purchasing and holding real estate is a common example of asset or capital appreciation, but in this case we're talking about the stock market. Put simply, what this means is that you're buying something and selling it for a higher price down the road.
For example, purchasing a stock valued at $20 per share and then selling it five years down the line for $100 per share would net an $80 gain (in realized returns) per share purchased.
Capital Appreciation and Depreciation Example
The chart below compares Amazon (AMZN) to Pacific Gas & Electric (PCG), and illustrates what capital appreciation and depreciation look likes over time:
In short, when you invest in individual stocks, there's always the chance that you can lose all of it, which is something you should always be aware of as a stock picker.
Dividends
Dividends are regular cash payments paid out to shareholders for owning their stock. Many established companies pay out quarterly dividends, but some are monthly or annual as well.
Dividend stocks are also known as income stocks, as they provide cash flow to investors in the form of dividends. These dividends are not guaranteed, but the best dividend-paying companies will generally continue to pay out increasing amounts of dividends every year, as it keeps shareholders invested in the company.
Many times, dividend investors will look for companies that have a track record of paying out dividends. By reinvesting the dividends they earn, they are able to earn exponential amounts of income through compound interest.
Compound interest takes place when the money you invest grows, or compounds overtime. The longer your money is in the stock market, the more compounding will happen. In addition, by collecting and reinvesting these dividends, more money can be compounded.
Principle #2: Buy Low, Hold, Then Sell High
As mentioned before, money is made in the stock mark through capital appreciation and/or dividends. These are the two primary ways people have made money in the stock market.
Money is NOT made by buying high and selling low (unless you're shorting a stock), buying something else at a high due to the fear of missing out (FOMO), and then selling the next week and repeating this cycle.
Many people are caught up in this pattern where they purchase a stock when it's at a high, due to hype, for example, and sell it the next week because it didn't work out. They then repeat this pattern over and over again every week while continuing to recognize small or even big losses over time.
Remember, its not buy high and sell higher, but buy low and sell high. This is the most important principle to understand. Being a stock market investor is a long term investment, typically one to five years or even longer, depending on your goals and investment strategies. You will also save money with your taxes as well if you're a long-term investor.
Principle #3: Recognize and Avoid Speculative Bubbles
Avoid speculative bubbles at all costs! Speculative bubbles form when the "herd" moves into a particular asset.
Here are a few speculative bubble examples:
So, as a general rule of thumb, if your friend who knows nothing is buying into a particular asset, run far, far away! This is a sign that the herd has moved into a particular investment.
Back in 2017, you saw people who knew nothing about cryptocurrency getting into it and buying it. This is when a speculative bubble reaches its peak and you get out at all costs. All of these people in the Bitcoin bubble bought Bitcoin at all time highs.
To untrained investors, Bitcoin had nowhere to go but up. Seasoned investors, on the hand, knew better and ran away from this Bitcoin trend. Bitcoin then went as low as $3000 after this bubble burst and now it's at a much higher price.
Ironically, what you will find is that stocks are the only thing that the average person does not buy on sale.
Principle #4: Ignore the Noise
Noise is everywhere when it comes to the stock market. In most cases, the best move to make is to do nothing!
Keeping up with the stock market drama is a great way to make a poor investment decision. Do not listen to random people on the internet and do not just take their advice and suggestions when it comes to investing in the stock market! When investing in the stock market, you need to make emotionless decisions. If you find yourself purchasing a stock 30 minutes before the stock market closes, in most cases, you're probably making an emotionless decision.
My best piece of advice to you, therefore, is to turn off the talking heads! Formulate your own well researched opinions and sleep easy at night. Don't let noise impact your investing decisions.
Here's what I would do. I would check on my stocks once a day, maybe twice depending on my investments. I would also keep track of the major company announcements, quarterly earnings reports, and annual reports. Beyond that, the rest is just noise.
Your investment strategy needs to be scalable and repeatable. Therefore, even though investing in stocks and discussing stocks with your friends may be a hot topic, you should first be careful about where you get your advice from, and second, ignore what your friends or family tell you and do your own due diligence.
Principle #5: Stock Market = Pendulum
As a stock picker, you want to buy from the pessimists and sell to the optimists. Optimism is equal to greed and pessimism is equal to fear. The stock market is like a pendulum. It's always going to be swinging back and forth from fear to greed and it's a continual cycle that will never end.
"The stock market is like a pendulum, forever swinging between unsustainable optimism and unjustified pessimism."
- Benjamin Graham
Fear is when you should buy low and greed is when you should sell high. Many people are therefore unsuccessful because they follow the crowd and purchase during moments of greed. So, although this is easier said then done, do your best to remember this when you are tempted to purchase a stock at a bad price.
Principle #6: Diversify Your Investments
One of the biggest mistakes new investors make is investing all of their money into one particular stock.
Why should we avoid purchasing only one stock? Well, simply because if something goes wrong with the stock you bought, regardless of how safe it is, you could potentially lose a lot of money.
This may be fine if you're investing only ~$1000 or less, depending on the stock. This is not fine, however, if you're investing thousands or tens of thousands of dollars. This is not a sane thing to do!
Diversification becomes increasingly more important as you invest more and more money into the stock market. As a general rule of thumb, you should never put more than 5% of your money into one particular asset. Granted, this can vary drastically with the amount of money you have invested and the investment strategy you're following.
Principle #7: Dollar-Cost Averaging
Many investors attempt to time the market, based on emotions, past market "trends," news, or other factors and invest all of their money at once after they think the market has hit the bottom. This is a foolish thing to do, as no one can really accurately predict where the market or particular stock will move.
Instead, what you should do is dollar-cost average your investments. What this means, is to simply spread out your investments over a period of time in relatively even amounts, so as to get the "average" of the market. For example, instead of spending $1000 to purchase shares in a company, spend this $1000 over a 5-day or 10-day period. You would do this to ensure you're not purchasing at all-time highs that crash the next day, or market lows that become even lower.
It makes sense at times to not dollar-cost average, especially with lower investment amounts, but it's a principle you should follow nonetheless.
Principle #8: Do Not Over-Diversify
If you are looking for diversified exposure to the market, buy an index fund that follows the S&P 500 market!
All you have to do is "dollar-cost average" your investments into dummy-proof index funds such as Vanguard or BlackRock, and you're essentially done. Do not, however, buy dozens of different stocks. Some people with small portfolios (less than around $50,000) own an excess of 50 stocks! This is just unorganized chaos and will stress you out. If you own this many stocks, you're confusing diversification and should just purchase an index fund.
A general rule of thumb as a beginner is to own no more than five stocks, given you have around $5000 to invest. Keep track of earnings dates, annual reports, major company news, and more. Even owning five company stocks is enough to keep you busy.
Principle #9: Understand Share Price Value
Simple logic would tell us that a $5 stock is cheap and a $5000 stock is expensive, but this is completely false! It simply has to do with how many shares are available.
Market capitalization = Outstanding shares * Share price
The formula above will tell you what the market is giving as a value for a particular company. Some are worth millions, some are worth billions, some are worth hundreds of billions. Very few companies are actually trillion dollar market cap companies.
Berkshire Hathaway Example
An example of this is Berkshire Hathaway's BRK-A Class-A stock and BRK-B Class-B stock.
Compare "BRK-B" to BRK-A, and you will notice that they follow the exact same stock market pattern.
As of writing, BRK-A., which has never been split, trades at $489,800 per share, making it the most expensive stock of all time. BRK-B, on the other hand, has been split to make it more accessible to investors and trades at $326.
Stock Splits
To better understand stock splits, let's look at the example below with Company A and Company B:
Company A: $1 Bil. = 100,000,000 outstanding shares * $10 per share
Company B: $1 Bil. = 1,000,000 outstanding shares * $1,000 per share
Clearly, what you can see here is that Company A has the same value as Company B! There's a lot more to determining the value of a company, but assuming all other factors are the same, these two companies would have the same valuation.
Point being, going out there and buying penny stocks, stocks that are extremely volatile and priced at less than $5.00, is typically not a better bang for your buck. More often than not you will lose a lot with these penny stocks. What this also means is that you should not decide to invest in one stock over the other, just because of its share price, especially considering that popular brokerages offer fractional share investing now.
Principle #10: Long Term Tax Advantage
There is a significant tax advantage associated with being a long term investor versus a short term trader. To begin, short term capital gains (1 to 365 days) are taxed as ordinary income, the highest rate.
On the other hand, long term capital gains (366 days or more) are taxed at a lower rate, saving you as much as 20% depending on what tax bracket you fall into.
You can read more about capital gains and tax rates on the IRS website, and then apply it to your income tax bracket situation.
The Bottom Line
In summary, understanding and following these 10 investment principles will help your investment portfolio grow consistently over the long-run. These simple investment principles alone, as obvious as some may be, are frequently overlooked and/or ignored by many investors, largely due to a lack of knowledge and emotional investment decision. Lastly, besides these 10 investment principles, understanding the power of compound interest is also a must for all stock market investors.