The Stock Market
for Beginners Part 4

The “Key” to Equity Investing

You’ve probably heard the age-old advice, “Buy low, sell high” many times. Unfortunately, studies have shown time and again that this is far easier said than done. Many investors fail to do so for the simple reason that they caught up with the performance of the stock market itself. They hesitate to buy stocks because they believe they should time the market. They hold back in an attempt to dodge an anticipated market setback.

This strategy seldom works, even for the most seasoned investors. Timing the market successfully is very difficult – and mistiming it is usually very costly.

It may sound counter-intuitive, but your best bet is to ignore what the stock market is doing.

The best strategy for maximizing your returns is to buy-and-hold over the long term, with the understanding that the market will naturally fluctuate in value. For the overwhelming majority of investors, long-term investing produces far better returns than attempts to time the market. Here’s the hard truth — hesitation is much more likely to cut into long-term returns than mistiming the market.

Also, when you’re investing in equities, don’t spend your time trying to “hit home runs.” Commit yourself to a policy of never compromising on the quality of the stocks you buy. Investing in the shares of high quality companies reduces risk while allowing you to earn good returns over the long term. Sometimes investors mistakenly associate size with quality. But a large company does not automatically spell quality — and vice versa.

Quality companies are distinguished by the following factors:

• Solid financial outlook. It has low debt compared to industry peers and a strong track record of earnings growth.
• Dividends. It has a history of rising dividend payments and forecasts of continuing dividend increases.
• Business outlook. The company should be in a relatively stable industry with a positive outlook for the company’s products or services.
• Experienced, solid management team that adheres to its plans and has been able to ride out tough times in the past.

The Most Common Pitfalls of Equity Investing:

1. Owning too many or too few stocks.
2. Buying stocks when everyone else is buying — usually the wrong time.
3. Buying stocks randomly without a financial plan.
4. Failing to sell bad stocks.
5. Selling strong stocks too soon.
6. Buying shares of companies the investor doesn’t fully understand (everyone knows that Research in Motion makes the Blackberry, for instance, but do you have a handle on what other software companies produce?).
7. Unrealistic expectations.
8. Buying Canadian stocks to the exclusion of all others.

Core Principles of Equity Investing:

1. Let time be on your side. Too many investors pull the trigger too fast on their investments. When the going gets tough they sell. The key to investment success is to focus on the long term and ride out short-term price fluctuations. By focusing on the day-to-day fluctuations in price, you can become overly worried about the natural dips of the stock market, which will erode your ability to make sound investments decisions.

The longer equities are held, the better they tend to perform. This doesn’t mean that you should hold onto poor quality companies or situations that have turned sour.

It means that if a stock’s price drops, look for concrete answers instead. Has their been any negative news or are stocks down in general as a result of natural market fluctuations? If the company’s fundamental strengths (strong balance sheet, good management, growing market share and so on) haven’t changed significantly, you’re better off holding high-quality stocks with a bright outlook for the long term.

2. Pick stocks with a track record of increasing dividend payments. Dividend growth is the best indicator of profitability – and that is what ultimately drives share prices up over the long term. You can also take it as a company’s statement of self-confidence. For you, it’s an effective way to ensure future income. The growth rate of a company’s dividends is a more important gauge than the current dividend rate. Dividend reinvestment is a better way to build wealth than collecting the income from growing dividends.

NOTE: Wherever possible, investors should use the income from their fixed income investment for living and day-to-day expenses, and reinvest the dividend income they receive from stocks.

3. Diversify, Diversify, Diversify. Diversification is a word you will read many times over when you pick up investment literature. And it’s worth remembering. Diversifying within your equity portfolio is just as important as how you allocate your assets between equities and fixed income.

Investing all your money in a small number of stocks can be a dangerous way to invest. What happens if one or more of those companies fall on hard times? The more stocks you own, the less damage one poorly performing stock will have on the overall portfolio. You should diversify among different and types of stocks. Your portfolio should be grounded on a solid base of strong, dividend paying stocks. Then you can add in mid cap, small cap or even penny stocks to add some capital gains growth to the mix. How you balance these elements will depend on your personal tolerance for risk.

How many stocks should you buy? Studies have shown that the optimal number of stocks is roughly 12 to 15. Most investors should err on the lower end of the scale. Too many stocks can be difficult to track and monitor, especially for novice investors.

Click here for The Stock Market for Beginners Part 5.