The truth is there’s no guarantee of being a great stock investor. Even top investors can slip from years of high performance to equally long losing streaks.
However, what you can do is improve your chances of success through discipline, patience and some helpful tips.
And despite what Hollywood might have you believe, those tips are not about Wolf of Wall Street style-bravado, flashy suits or flipping assets 24/7 from your high-rise office.
These are our five tips for improving your investing skills and getting started.
Let’s jump right in.
1. Diversify your investments
Diversification is an essential part of the stock investor’s playbook.
In the simplest terms, diversification can be summed up by the phrase: “Don’t put all your eggs in one basket.” And effectively diversifying your investment portfolio means spreading your investments across a range of assets and types of investments.
For example, if your stock portfolio consisted only of U.S. tech stocks like Twitter and Facebook, you would have seen your portfolio value slide when tech stocks were hit hard in Q4 2018. But if tech stocks were just a part of your portfolio alongside various ETFs, bonds and assets, the tech industry’s Q4 decline wouldn’t have had such an impact on your overall portfolio.
Essentially, diversification helps protect you from risk . As we explained in our post on diversification:
“By reducing your exposure to any particular stock or industry, you reduce your vulnerability to the unpredictable and predictable problems any company can face.”
When you’re building your portfolio it’s important to spread your investments across a range of stocks from different industries, countries and company growth stages.
2. Invest in what you know
No investment is ever guaranteed positive returns. But you have a higher chance of success if you invest in areas you know and understand.
Legendary investor Warren Buffet calls this your ‘Circle of Competence’. As Buffet explained in Berkshire Hathaway’s 1996 shareholder letter:
“What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
And over the years, each of us — no matter our careers or background — has built up knowledge and understanding of how certain parts of the world work.
Buffett, for instance, knows a lot about ice cream
For example, if you work at a supermarket, you probably know a little about the ins and outs of that industry: What products people are buying, the most popular brands, your employers performance vs competitors, for example.
But you probably wouldn’t know quite so much about a large pharmaceutical company or construction company.
Before you buy your next stocks, try to write down 15–20 companies you know a little about — think about all aspects of your life and write down the brands that come to mind. For example:
- Work: Dropbox, Adobe, Apple, Intuit, Okta
- Entertainment: Cineworld, Netflix, Spotify, Sony
- Retail: Nike, Amazon, Debenhams, eBay, Etsy, Ted Baker
- Food and drink: Tesco, Diageo, Coca-Cola, Dominos Pizza, Just Eat
From here you can start to research each of those businesses (their stock prices and historical performance), and look at whether they might be a good prospect for you to consider.
This approach has worked well for plenty of investors, including American investor, Peter Lynch, who made millions by purchasing stocks in businesses he, or people close to him, first experienced as consumers.
One of the most famous examples of this from Lynch’s career was his investment in Hanes after his wife had shared how happy she was with their products.
Of course, even the best research doesn’t guarantee success, but it can help your odds!
3. Have a cash fund for emergencies
When you invest, you should only use as much money as you’re comfortable not touching for some time and ensure you maintain a cash reserve.
Before you invest you should first have at least enough cash saved to cover a few months of expenses.
“But how does this make me a better stock investor?”
Having your money in a cash savings account will currently earn you next to nothing in interest (you may even become poorer when you consider inflation), but it means you’re covered if anything unexpected disrupts your income.
Your emergency fund isn’t there to make you money, it’s a safety net to protect you against any financial downturns you may experience.
Investing is a long-term game and you don’t want to have to sell your investments prematurely to cover month-to-month costs if anything changes with your income.
Saving cash gives you the financial freedom to deal with any financial ups and downs you experience outside of the stock market.
4. Don’t be swayed by short-term volatility
Market volatility is an unavoidable part of investing.
The stock market rises and falls daily — this shouldn’t necessarily cause panic.
Diversification and long term investing both help to ride out short term volatility. Of course, stock market crashes happen and the value of your portfolio can take a long time to recover.
But with instant access to our investments at our fingertips it can be easy — and even a little addictive — to check in on your stocks all too frequently. And you don’t have to panic every time you see a stock dip.
This doesn’t mean you should always hold on to a losing investment. An individual stock that’s plummeting for good reasons — debt, waning business fortunes — won’t necessarily recover.
5. Set realistic expectations
In 2018, CNBC revealed that if you had invested $1,000 during Amazon’s IPO in May 1997, your investment would be worth $1,362,000.
But these type of investment stories are few and far between. If you try this approach, it’s very possible you’d have picked a Pets.com instead (current value: zero)!
Chances are you won’t invest in the next business unicorn at the perfect time and great stock investors keep their expectations realistic. That’s why it’s important to split your money between investments.
Returns of 6–7% annually tend be a good benchmark for stock investors over the long-term. Warren Buffett explained the reasoning behind this number to Bloomberg:
“The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent, Buffett said. Stocks will probably rise at about that rate and dividend payments will boost total returns to 6 percent to 7 percent, he said.”
And if you take a look at the historical performance of the S&P 500 between 1950–2009 the real total return (adjusted for inflation and accounting for dividends) sits at 7%.
Nothing is a sure bet and past performance isn’t a guarantee for future results, but as an investor you should be looking to set your expectations somewhere around 7% for long-term performance. Don’t expect double digit returns as a given!
These are a few of the most important tips to upgrade your investing game. But there is no recipe.
This piece was written by a Freetrade contributor
Freetrade does not provide investment advice and individual investors should make their own decisions or seek independent advice. The value of investments can go up as well as down and you may receive back less than your original investment. Tax laws are subject to change and may vary in how they apply depending on the circumstances.