As you begin investing, you need to learn to ignore the static and stick to your game plan.
But over the years, many old chestnuts have fallen, half-rotten, to the ground — even Warren Buffett’s exuberant 1990s dictum that “our favorite holding period is forever.” Tell that to anybody who bought Cisco (CSCO) at $146 in March 2000. Even some very good businesses can get so overpriced that hanging on for a lifetime won’t bail you out.
So how do you come up with a solid plan? Well, certain commonsense investment principles have proven their worth time and time again.
Value, Always Key
The first, and most important, rule that has worked for centuries (and still works today) is “Buy cheap, sell dear.” It’s almost laughably easy to grasp, yet difficult for most investors to act on. Overpriced assets tell an enticing story. Growth, new technologies, “inevitable” trends, charismatic business chiefs — all can keep us from asking the bedrock question, “How much is it really worth?” Ponder this issue carefully before you lay a nickel on Tesla (TSLA) or the next Facebook-like (FB) IPO!
You’ll catapult your odds of investment success if you buy things that are objectively cheap, not just depressed in price. When picking stocks, for example, look for proof of intrinsic value, such as a generous dividend yield, a large amount of free cash flow relative to the share price, or a well-established pattern of stock buybacks that significantly shrink the number of shares outstanding.
“Selling dear” calls for objective standards, too. You should carry around in your head a price at which you would consider each of your investments fully valued (and thus ripe for sale). That price will adjust, up or down, as the fundamentals supporting the investment change.
Say, for instance, a company slashes its dividend. In that case, the stock might be richly valued, even at a lower price than you paid. Watch for a temporary bounce as your chance to exit the position.
Diversification for Safety
The second truth that has stood the test of time is diversification. A couple of years ago, the financial news media were lionizing money managers who ignored this principle. By concentrating your portfolio on a few “great ideas,” you could strike a bonanza while the rest of us suckers were just plodding along.
Hedge-fund star John Paulson was the poster boy for putting all your eggs in one basket. In 2008, when he was a relatively small operator and largely unknown, Paulson reaped billions from placing a go-for-broke wager on the housing collapse. Over the next two years, as word of his success got around, investors banged down the doors to gain entrance into his highly concentrated funds. By the start of 2011, he had $38 billion under management.
Uh-oh. During the first half of 2013, his highly touted PFR Gold Fund cratered 65%, according to Bloomberg.
Live by the sword, die by the sword!
For the great majority of investors, it’s wiser to spread your risks around. Within the stock segment of your portfolio, never allow any single company to hog more than 5%. Gold, collectibles and other “alternative” assets should normally make up 10% or less of your total — probably much less under today’s circumstances.
My third enduring principle is that of low turnover and low cost. The two are actually intertwined, because you tend to lower your costs (commissions, taxes, wrong timing decisions) if you trade less frequently.