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10 tips to become a SMART stock market INVESTOR

Last updated on: June 26, 2012 17:01 IST

10 tips to become a SMART stock market INVESTOR

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Morningstar.in

We've boiled down some of our most salient observations into 10 suggestions we think will make you a better stock investor.

At Morningstar globally, our analyst staff has about a thousand years of collective investment experience. Here, we've boiled down some of our most salient observations into 10 suggestions we think will make you a better stock investor.

1. Keep it simple

Keeping it simple in investing is not stupid. Seventeenth-century philosopher Blaise Pascal once said, 'All man's miseries derive from not being able to sit quietly in a room alone'. This aptly describes the investing process.

Those who trade too often, focus on irrelevant data points, or try to predict the unpredictable, and are likely to encounter some unpleasant surprises when investing.

By keeping it simple -- focussing on companies with economic moats, requiring a margin of safety when buying, and investing with a long-term horizon -- you can greatly enhance your odds of success.

Courtesy 


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2. Have the proper expectations

Are you getting into stocks with the expectation that quick riches soon await? Hate to be a wet blanket, but unless you are extremely lucky, you will not double your money in the next year investing in stocks.

Such returns generally cannot be achieved unless you take on a great deal of risk by, for instance, buying extensively on margin or taking a flier on a chancy security. At this point, you have crossed the line from investing into speculating.

Though stocks have historically been the highest-return asset class, this still means returns in the 10 per cent to 12 per cent range. These returns have also come with a great deal of volatility.

If you don't have proper expectations for the returns and volatility you will experience when investing in stocks, irrational behaviour -- taking on exorbitant risk in get-rich-quick strategies, trading too much, swearing off stocks forever because of a short-term loss -- may ensue.


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3. Be prepared to hold for a long time

In the short term, stocks tend to be volatile, bouncing around every which way on the back of Mr. Market's knee-jerk reactions to news as it hits. Trying to predict the market's short-term movements is not only impossible, it's maddening.

It is helpful to remember what Benjamin Graham said: In the short run, the market is like a voting machine -- tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine -- assessing the substance of a company.

Yet all too many investors are still focussed on the popularity contests that happen every day, and then grow frustrated as the stocks of their companies -- which may have sound and growing businesses -- do not move. Be patient, and keep your focus on a company's fundamental performance. In time, the market will recognise and properly value the cash flows that your businesses produce.


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4. Tune out the noise

There are many media outlets competing for investors' attention, and most of them centre on presenting and justifying daily price movements of various markets. This means lots of prices -- stock prices, oil prices, money prices, frozen orange juice concentrate prices -- accompanied by lots of guesses about why prices changed.

Unfortunately, the price changes rarely represent any real change in value. Rather, they merely represent volatility, which is inherent to any open market. Tuning out this noise will not only give you more time, it will help you focus on what's important to your investing success -- the performance of the companies you own.

Likewise, just as you won't become a better football player by just staring at statistical sheets, your investing skills will not improve by only looking at stock prices or charts. Athletes improve by practicing and hitting the gym; investors improve by getting to know more about their companies and the world around them.


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5. Behave like an owner

We'll say it again -- stocks are not merely things to be traded, they represent ownership interests in companies. If you are buying businesses, it makes sense to act like a business owner.

This means reading and analysing financial statements on a regular basis, weighing the competitive strengths of businesses, making predictions about future trends, as well as having conviction and not acting impulsively.


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6. Buy low, sell high

If you let stock prices alone guide your buy and sell decisions, you are letting the tail wag the dog. It's frightening how many people will buy stocks just because they've recently risen, and those same people will sell when stocks have recently performed poorly.

Wake-up call: When stocks have fallen, they are low, and that is generally the time to buy! Similarly, when they have skyrocketed, they are high, and that is generally the time to sell! Don't let fear (when stocks have fallen) or greed (when stocks have risen) take over your decision-making.


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7. Watch where you anchor

If you read our article on behavioural finance, you are familiar with the concept of anchoring, or mentally clinging to a specific reference point. Unfortunately, many people anchor on the price they paid for a stock, and gauge their own performance (and that of their companies) relative to this number.

Remember, stocks are priced and eventually weighed on the estimated value of future cash flows businesses will produce. Focus on this.

If you focus on what you paid for a stock, you are focussed on an irrelevant data point from the past. Be careful where you place your anchors.


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8. Remember that economics usually trumps management competence

You can be a great rally driver, but if your car only has half the horsepower as the rest of the field, you are not going to win. Likewise, the best skipper in the world will not be able to effectively guide a yacht across the ocean if the hull has a hole and the rudder is broken.

Also keep in mind that management can (for better or for worse) change quickly, while the economics of a business are usually much more static. Given the choice between a wide-moat, cash-cow business with mediocre management and a no-moat, terrible-return businesses with bright management, take the former.


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9. Be careful of snakes

Though the economics of a business is key, the stewards of a company's capital are still important. Even wide-moat businesses can be poor investments if snakes are in control. If you find a company that has management practices or compensation that makes your stomach turn, watch out.

When weighing management, it is helpful to remember the parable of the snake.

Late one winter evening, a man came across a snake on the path. The snake asked, 'Will you please help me, sir? I am cold, hungry and will surely die if left alone.'

The man replied, 'But you are a snake, and you will surely bite me!'

The snake replied, 'Please, I am desperate, and I promise not to bite you.'

So the man thought about it, and decided to take the snake home. The man warmed the snake up by the fire and prepared some food for the snake. After they enjoyed a meal together, the snake suddenly bit the man.

The man asked, 'Why did you bite me? I saved your life and showed you much generosity!'

The snake simply replied, 'You knew I was a snake when you picked me up.'


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10. Bear in mind that past trends often continue

One of the most often heard disclaimers in the financial world is, 'Past performance is no guarantee of future results.' While this is indeed true, past performance is still a pretty good indicator of how people will perform again in the future. This applies not just to investment managers, but company managers as well.

Great managers often find new business opportunities in unexpected places. If a company has a strong record of entering and profitably expanding new lines of business, make sure to consider this when valuing the firm. Don't be afraid to stick with winning managers.


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