Five Rules for Successful Stock Investing

Stock market investing can be a good long-term strategy.

The stock market can be a volatile place, but stock market investments can still form the basis of sound investing strategy. Despite their periodic dips, stocks have still tended to outperform other types of investments over the long term, and that makes stock market investments a good choice for those with a long-term time horizon. A recent study by the Brookings Institute looked at stock market returns from 1871-1998 and found an average real return of 6.3% per year, although the year-to-year returns varied quite widely. To succeed as a stock market investor, individuals will need to understand that stock prices can swing quite widely in a short period of time.

Diversify Your Holdings

Diversification is one of the most critical elements of any stock market portfolio, and it is essential for all stock market investors to spread risk as much as possible. This is the old adage to not put all your eggs in one basket. There are a number of ways to diversify your holdings, including buying mutual funds instead of individual stocks. Mutual funds pool the money from many different investors and use that money to buy large baskets of stocks. A typical mutual fund will hold from dozens to hundreds of different stocks, and this can significantly reduce the risks associated with stock market investing.

Limit Exposure to Your Company Stock

Many workers have the opportunity to buy stock in the companies they work for, either through the company 401(k) plan or through an employee stock purchase plan, or ESPP. In the case of an ESPP, employees are often offered a discount on the stock, generally between 5% and 15% below market value. While these plans can be excellent opportunities, it is important to limit your exposure to the company's stock. When investing in your company's stock, keep in mind that you already rely on the company for your income--adding stock to the equation makes you even more dependent on the good fortunes of the company. Limiting your company stock exposure to 5-10% of your total stock market holdings can reduce your risk while allowing you to participate in the growth of the firm.

Only Buy What You Understand

Many of the biggest crashes in stock market history have been caused by seemingly smart investors who purchased financial instruments they simply did not understand. From credit default swaps and debt securities and derivatives, there are many complicated investment vehicles on the market. Restricting your stock market investments to what you actually understand is an important part of stock market investing. Famed investor Warren Buffett stresses this concept often by stating that he only buys companies he understands. If you cannot explain what a particular company actually does or understand how it makes money, it may be best to pass on the opportunity.

Compare Your Results to the Indexes

Keep your costs low.

It is important for all stock market investors to keep track of how they are doing relative to the stock market indexes. This is especially important because you can always purchase an index mutual fund or exchange traded fund. Investing in the index itself will guarantee you the return that index generates, all for a very low cost. If you choose to invest in managed mutual funds, it is important to look at their performance each year and assess that performance based on the appropriate index. For instance, a stock market fund should be compared to a widely tracked index like the Standard and Poor's 500 index fund. If you find that your managed funds are consistently outperforming the market you can be sure that you have found a good investment. If, on the other hand, you find that your investments are not keeping pace with the index, it may be best to abandon those funds and buy the index instead.

Control Your Costs

No matter how you invest your money, it is important to keep your costs under control. Investment costs can quickly add up and cost you thousands of dollars, so it is important to know exactly what you are paying on each of the mutual funds you own. Before investing in any fund, it is critical that you obtain a prospectus which lists the annual expenses and fees associated with that fund. Keep in mind that you can purchase a quality index mutual fund for an expense ratio of less than 0.20%. If you plan to buy individual stocks it is also a good idea to keep your trading costs as low as possible. There are a number of discount brokers who charge less than $10 per trade, so if your costs are significantly more, you may want to seek out another broker.

References

• Brookings Institute Stock Market Returns
• Warren Buffet's Advice