To be a successful investor you have to avoid the natural human instinct to follow the herd.
When the stock market goes down, your natural tendency is going to be to want to sell, and when the stock market is going up, your natural tendency is going to be to want to buy.
In bubbles, you should be a seller, not a buyer. In busts, you should be a buyer.
You have to have the discipline to stomach the volatility of the stock market.
Here are five key ways to develop the strength to go against the herd.
1. Be Financially Secure
First of all, you have to have some savings.
You’ve got to feel comfortable that you have enough money in the bank that you don’t need what you have invested for many years to come.
Some people think it’s a shame not to invest every penny that they have. In their world, cash not invested is a waste.
If that’s your thinking, I suggest you think about it this way instead: your cash savings are buying you something very valuable and specific, and that’s peace of mind and the ability to stomach market volatility. You should have at least two types of savings:
A. An emergency account for a car repair or a new fridge. This should be at least $5,000 that are always available.
B. A security savings of either three months’ salary or six months’ expenses. This should also be ready in cash. Apart from giving you peace of mind on the stock market, it will also make it easier for you to take some bold career moves and set boundaries at work.
2. Don’t Leverage
Don’t invest with borrowed money.
Most people know not to take an expensive bank loan and invest the money or speculate with the money.
But there is a different way of borrowing money that is not so obvious to the eye. Many platforms let you invest with leverage – almost without you noticing it: it’s called a margin account. You should avoid this. You should never invest more than you have.
Investing with leverage has destroyed many good investors, even good value investors who were peers of Warren Buffett.
Call your brokerage platform to make sure that you’re only investing your own money if you’re not sure.
Some more complex financial products contain leverage, but if you are just selling and buying stocks, you are safe.
3. Don’t Get Spooked by the Market
Just because something goes down in value after you buy it, it doesn’t mean you’ve made an investing mistake.
Keep your focus on the long term prospect.
The stock market moves up and down all the time.
In the short term it’s a voting machine, whereas in the long term it’s a weighing machine.
It’s affected by all kinds of events in the world, and few of these events have anything to do with the business of the company that you are invested in. This is just the nature of volatility. But don’t worry, if your company is sound and has some competitive advantages, the stock price will straighten itself out in the long run.
If it’s any consolation Warren Buffett has also invested in companies just to see the stock price drop further. One example is The Washington Post which he invested in during the 1970s. More than a year after he initially invested in the newspaper, the stock price was down 25 percent.
This investment later turned into a profitable one. Four decades later, Buffett exited the position (the original investment of $10 million) in a tax free swap worth more than $1 billion.
4. Research Your Companies
Don’t buy a stock because someone in a podcast predicted high returns and a glorious future for the company.
Research the companies you invest in. Analyse it the way you would, if you were buying the entire company.
- Make sure it’s a business you understand.
- Make sure you like the management.
- Make sure that the company has some kind of competitive advantage.
- Make sure the company doesn’t have too much debt.
It’s a good idea to use some kind of checklist. You can borrow mine here.
5. Pay a Reasonable Price
The price of the stock should be reasonable compared with the earnings of the company.
I usually say ‘buy it when it’s cheap’, but I fear that many people will think a stock is cheap if it has fallen from a recent high, and that isn’t necessarily the case.
You really have to look at the value in the company and compare the stock price to that.
Let’s go back to Washington Post for a moment. Warren Buffett had calculated that it was priced at 25 percent of the intrinsic value before investing in it. That’s like buying one dollar for 25 cents. That it fell to 20 cents on the dollar does not make the original investment bad. It means you might want to consider buying some more since it’s an even better investment now.
What if they have no earnings? Don’t invest in it then.
Companies with no earnings or negative earnings are too risky to invest in.
How do you know if the price of the stock is reasonable? If you want to learn how Warren Buffett calculates the value of companies, you are welcome to download my free e-book here.