1. Invest for the Long Term
If you invest for the long term, you give your stocks a chance to increase in value and/or pay out dividends. Every stock has its up and downs and nobody is able to consistently predict if a stock will rise or fall tomorrow. However, history has shown us that the majority of stocks will tend to rise in value over the years. Take a look at the S&P 500 chart below for example:
After every major downturn, the S&P 500 has bounced back to places higher than it was before the fall. If you invest in the long term and let your stocks grow, chances are that you will buy low and sell high. If you attempt to time the market, you may just end up doing the opposite, buying high and selling low. As long as you do the proper research before purchasing a stock, you will probably pick a winner in the long run. Ignore all the big headlines about stocks you should buy or sell and go with your research instead. If you dump a stock because it slumped a little bit today or because the TV told you to, you may miss out on big gains tomorrow.
Also, when you invest for the long term, you pay less taxes on any capital gains you may make. If you buy a security and hold on to it for less than a year before selling, you pay regular income tax on any capital gains. However, if you purchase a stock and hold on to it for more than a year, then you would only have to pay a 15% tax on any capital gains.
2. Diversify
Don't place all of your money into a single stock. Unless you have some ridiculously accurate inside information, you are making a gigantic gamble when you place all of your money on a single stock. When you do so, the outcome of your portfolio will solely be based on the outcome of a single company. If the company does well, you'll prosper, but if it doesn't, your portfolio will go down the drain. You might as well go to a roulette table and bet it all on black. A company that seems healthy one day may go bankrupt the next.
Example: A year ago, a share of Washington Mutual Inc. (WM) was worth $36. A few months ago, they were being trade for pennies a share. Now, the ticker symbol doesn't even exist anymore.
Diversification doesn't just end at investing outside of a single company; you have to expand outside of the industry as well. When one company in a particular industry is doing poorly, chances are that the other companies in the same industry are doing poorly as well, so don't place all of your money into a single industry. If a problem affects an entire industry, your investments could take a huge hit.
Example: The Dot-com crash is a great example of this. For about 5 years, there was a massive increase in internet based companies with poorly planned business models. Everybody believed that the internet was the future of the world, but when they realized that it just wasn't meant to be, the dot-com bubble burst and trillions of dollars in peoples portfolios disappeared. For a more recent example of why you shouldn't invest in a single particular industry, just take a look at the financial sector. Anyone who had his or her portfolio invested too heavily in financial stocks is definitely feeling the pain with all the bank close outs.
Believe it or not, there are even more ways that you can broaden and diversify your investments. The last bit of advice I have for diversification is: don't put all of your money into a single type of investment. Fact: You can invest in things outside of stocks. (Shocking isn't it?) You could invest your money in other things such as bonds, real estate, gold, Treasury securities, or even a plain old high yield savings account. The reasoning behind diversifying beyond a single type of investment is the same as the others; if one investment in your portfolio tanks, the others will be doing well enough to at least help you break even or stay near even. Who knows, maybe you'll even still maintain a profit, depending on how well diversified you are.
Example: If you want a current example as to why you should invest beyond stocks, just take a look at the market today. Anyone who had their portfolio or 401k invested in stocks only has had much of their wealth wiped out. However, people that chose to invest in things such as bonds and treasury notes aren't suffering as much of a loss as a majority of the others.
3. Never Invest More than You Can Afford To (And Always Keep an Emergency Fund)
There's no better way to illustrate this point than with an example. Let's say John has $50,000 saved up and he decides that he wants to use that money to start investing. John does all the proper research, carefully analyzing each company's financial statements and past historical trends. He finally narrows down the list of companies that he wants to invest in, and comes up with a well diversified portfolio, where he isn't invested too heavily into a single company or industry. John thinks to himself "Wow, this portfolio is so perfectly balanced and so well chosen that I'm practically guaranteed a high return! But with only %50,000 to invest, I won't be maximizing its full potential." So John goes around to a couple of his buddies to borrow money, promising a fair return for each person that lends him money. Now, John has gathered a full $100,000 and begins his investment.
Let's pretend six months have passed, and John was let go from his job. He still has absolutely no money saved up; all of his liquidity lies within his portfolio. This means that if John wants to continue to survive, he's going to have to sell off some of his securities. Now, one of three things could have happened with his portfolio: 1) The stocks could have maintained their value, 2) The stocks could have went up in value, or 3) The stocks could have declined in value.
If the stocks have maintained their value, then when John sells them, he would have lost money due to the commission he has to pay per trade. Also, the returns that John promised to his friends would have to be paid out of his own pocket.
If the securities went up in value like John envisioned them to, then he will realize a capital gain, which is great. Sort of. He still had to pull out his stocks way before he intended to which means that his picks didn't have time to grow to their full potential. Also, since John has held on to these securities for less than a year, he'll have to pay the full amount in income taxes for his capital gains, rather than the discounted 15% tax rate that he would have ended up paying if he held on to the stocks for another six months.
The last scenario is just the worst. John has done just the opposite of what he needed to make money in the stock market; he bought high and sold low. Not only did he realize a capital loss from his securities, he also lost money from the commission that he had to pay and from the returns that he promised his friends. Now that his money is out of the market, he'll miss out on any of the potential gains that he stood to make.
You should never invest more money than you have because you never know when an emergency may pop up and you'll be in dire need of cash. If all of your liquidity lies in your investments, then you may be forced to buy your stocks at a high point and sell them at a low point. The danger of this is amplified when you're buying on a margin or on a loan, as you'll now have to pay that money back along with any interest that may accrued, interest that you intend to pay off with capital gains that will never materialize because your money is no longer in the market. This is why you should always keep in cast at least six months worth of living expenses. That way, if an emergency does arise, you won't have to break into your portfolio. The stock market will continue to move whether your money is in there or not. It's up to you to decide if your money will be there long enough to ride through the ups and downs long enough to make you a profit.
I hope that these rules will help give you beginning investors a better idea as to how to build your portfolio. If you guys have anything that you'd like to point out or if you have any additional tips, then please feel free to leave a comment. If you have a question, then don't be afraid to ask; there is no better way to learn. I don't claim to know everything, but I'll be happy to share what I do know.
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