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When people panic you see a lot of short term fluctuation in share prices as a result of their behavior. 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.
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. 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.
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. 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 means investing a fixed amount of money on a regular basis. 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.
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. 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. 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 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. 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. 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.
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. 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. 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? 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.
Have you heard of Peter Lynch? 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. 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. 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. 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. The year is and all of your money is invested in Large Cap US companies. 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. 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.
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 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.
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.
If you can't beat 'em, join 'em. 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. Germany's version of the Dow. This is a Blue Chip stock index consisting of 30 major German companies. Popular German Index and a good measure of the health of the German economy. Good benchmark for any large cap German based stocks. Best-known and most widely followed market indicator in the world and a good measure of US economic health.
Perfect benchmark for Blue Chip, large cap and Income Investors. Good benchmark for any large cap UK based stocks. Popular Hong Kong Exchange index and a good measure of China's economic health. Good benchmark for any large cap Chinese stocks. Index of foreign stocks. Focuses only on developed countries in Europe, Asia and the far east. Good benchmark for anyone that has a portion of their portfolio allocated to developed foreign countries.
Good benchmark for anyone that has a portion of their portfolio allocated to developing foreign countries. This index is designed to reflect the overall market, there is no specific weighting of industries. Most watched index of Asian stocks and a good measure of Asia's economic health. Your choices include bonds such as municipal bonds that offer tax advantages. A better choice may be bond funds, which are a basket of bonds, with money pooled from different investors—much like a mutual fund.
Here are some bond characteristics you will want to avoid:. If you are trying to figure out the percentage your portfolio should have in bonds, you can follow the age-old rule, which, according to Burton Malkiel, famed author of "A Random Walk Down Wall Street" and respected Ivy League educator, is your age. Your main choice is whether or not to buy a property outright or invest through a real estate investment trust REIT. Both actions have their own advantages and disadvantages, but they can each have a place in a well-built investment portfolio.
One major advantage of real estate is that if you are comfortable using debt, you can drastically increase your withdrawal rate because the property itself will keep pace with inflation. There are three issues with this approach:. What percentage of your income investing portfolio should be divided among stocks, bonds, real estate, etc.? The answer comes down to your personal choices, preferences, risk tolerance, and whether or not you can tolerate a lot of volatility.
Asset allocation is a personal preference. The simplest income investing allocation could be:. While simple, this example allocation may not be what's best for you individually. If you are young and willing to take risks, you may allocate more of your portfolio toward stocks and real estate. The higher risk you take can potentially lead to higher rewards. If you are risk-averse, you may want to allocate more of your portfolio to bonds.
They are less risky and offer lower returns as a result. There is no one-size-fits-all portfolio. Saving money and investing money are different, though they both serve your overall financial plan. Even if you have a diversified income investing portfolio that generates lots of cash each month, it is vital that you have enough savings on hand in risk-free FDIC-insured bank accounts in case of an emergency.
Funds saved in a bank account are liquid and can be quickly withdrawn if needed. When all your funds are invested, your capital is tied up, and you could be forced to liquidate positions in order to get cash. Doing so could negatively affect your returns and tax efficiency. The amount of cash you require is going to depend on the total fixed payments you have, your debt levels, your health, and how fast you might need to turn assets into cash. Understanding the value of cash in a savings account cannot be overstressed.
You should wait to begin investing until you have built up enough savings to be comfortable about emergencies, health insurance, and expenses. Only then should you start investing. It's possible to make enough from your investments to cover your costs of living , but this doesn't happen overnight. It requires years of careful and disciplined investing and patiently allowing your wealth to grow. Once you do have enough invested to earn a full salary's worth in annual returns, you have to be careful not to withdraw more than what your investments earn each year.
Income investing is meant to provide a steady stream of income in the present or near future, while growth investing is meant to build up wealth that you will live off or grant to your heirs in the long term. While they're not mutually exclusive for instance, growth investments provide income during retirement , the two strategies generally differ in terms of how you invest and what you do with your invested funds. The amount you need for income investing depends on how much you're hoping to earn every month.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. Why That Brings New Worries.
Charles Schwab. Social Security Administration. Investor's Daily. Princeton University. Table of Contents Expand. Table of Contents. What Is Income Investing? Finding a Monthly Income Target. Key Investments for Income Investing.