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10 truths of getting rich through stocks

November 11, 2008

You will truly profit from investing only when you have a clear appreciation of its principles and realities.

Once you understand these, you will be better able to keep a cool mind during the inevitable ups and downs -- and reap riches by investing with controlled risks.

1. Investment rewards can only be increased by the assumption of greater risk

This fundamental law of finance is supported by centuries of historical data. US stocks have provided a compounded rate of return of 11 per cent per year since 1926, but this return came only at substantial risk to investors: total returns were negative in three out of ten years. Higher risk is the price one pays for more generous returns.

2. Your actual risk in stock and bond investing depends on the length of time you hold your investment

Holders of a diversified stock portfolio in the US, from 1950 to 2000, were treated to a range of annual total returns, which varied from +52% to -26%. There was no dependability of earning an adequate return in any single year. But if you held your portfolio for 25 years in the same period, your overall return would have been close to 11% -- whichever 25 years you were invested.

In other words, by holding stocks for relatively long periods of time, you can be reasonably sure of earning the generous rates of return available from common stocks.

3. Decide how much risk you are willing to take to get high returns

JP Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. Morgan advised him to 'sell down to his sleeping point'. He wasn't kidding.

Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. Your tolerance for risk informs the types of investment -- stocks, bonds, money-market accounts, property -- that you make. So what's your sleeping point?

4. Dollar-cost averaging can reduce the risk of investing in stocks and bonds

Dollar-cost averaging simply means investing the same fixed amount of money in, for example, the shares of a mutual fund at regular intervals -- say, every month or quarter -- over a long period.

It can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices.

5. Stock prices are anchored to 'fundamentals' but the anchor is easily pulled up and then dropped in another place

The most important fundamental influence on prices is the level and duration of the future growth of corporate earnings and dividends. But earnings growth is not easily estimated, even by market professionals.

In times of optimism, it is easy to convince yourself that your favorite company will enjoy substantial and persistent growth over an extended period. In times of pessimism, many security analysts will not project any growth that is not 'visible' and hence will estimate only modest growth rates for the corporations they follow.

Given that expected growth rates and the price the market is willing to pay for growth can both change rapidly on the basis of market psychology, the concept of a firm intrinsic value for shares must be an elusive will-o-the-wisp.

6. If you buy stocks directly, confine your purchases to companies that appear able to sustain above-average earnings growth for at least five years and which can be bought at reasonable price-earnings multiples

As difficult as it may be, picking stocks whose earnings grow is the name of the game. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiple (P/E) that the market is willing to pay for those earnings.

The purchaser of a stock whose earnings begin to grow rapidly has a potential double benefit: both the earnings and the multiple may increase.

7. Never pay more for a stock than can reasonably be justified by a firm foundation of value

Although I am convinced that you can never judge the exact intrinsic value of a stock, I do feel that you can roughly gauge when a stock seems to be reasonably priced. The market price earnings multiple (P/E) is a good place to start: you should buy stocks selling at multiples in line with, or not very much above, this ratio.

Note that, although similar, this is not simply another endorsement of the 'buy low P/E stocks' strategy. Under my rule it is perfectly alright to buy a stock with a P/E multiple slightly above the market average -- as long as the company's growth prospects are substantially above average.

8. Buy stocks with the kinds of stories of anticipated growth on which investors can build castle in the air

Stocks are like people -- some have more attractive personalities than others, and the improvement in a stock's P/E multiple may be smaller and slower to be realized if its story never catches on. The key to success is being where other investors will be, several months before they get there. Ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd.

9. Trade as little as possible

Frequent switching between stocks accomplishes nothing but subsidizing your broker and increasing your tax burden when you do realize gains. My own philosophy leads me to minimize trading as much as possible. I am merciless with the losers, however.

With few exceptions, I sell before the end of each calendar year any stocks on which I have a loss. The reason for this is that losses are deductible (up to certain amounts) for tax purposes, or can offset gains you may already have taken. Thus, taking losses can actually reduce the amount of loss by lowering your tax bill.

10. Give serious thought to index funds

Most investors will be better off buying index funds (funds that buy and hold all the stocks in a broad stock market index) rather than buying individual stocks.

Index funds provide broad diversification, low expenses and are tax efficient. Index funds regularly beat two-thirds of the actively managed funds with which they compete.

[This article by Burton Malkiel is excerpted from Investing Rules from the Masters: Money-Making Lessons from 105 of the World's Experts, published by Vision Books. Dr Malkiel is the Chemical Bank Chairman's Professor of Economics at Princeton University and author of the celebrated investment classic, A Random Walk Down Wall Street.

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