A lot of people are mesmerized by successful investment track records. These track records are typically displayed in a lot of investment advertisements around the web. It’s a way that marketers can grab your attention while making you feel that anyone can achieve those investment results, but I can tell you right now that is far from the truth.
The actual truth is that investing is quite simple. Any rational person with a decent IQ understands that in order to make money you have to “buy low and sell high” or receive a constant payment over long periods of time. What makes investing difficult is the irrational emotional behavior displayed by investors time and time again. Some may think ignorance is the main culprit but you would be surprised, in fact it is fear and greed that mainly drive this irrational behavior in the markets.
Greed can make the smartest of men and women blindly follow a path right off a cliff. All you have to do is reference the case study of Bernie Madoff. This hedge fund manager wasn’t swindling the common middle class, he was conning high net worth individuals. These individuals were doctors, lawyers, entrepreneurs, etc and considered highly intelligent. Unfortunately none of these individuals ever questioned how 20 Billion could be turned into 65 billion or how they could consistently achieve investment results of 20% or more a year.
Fear can make some of the easiest and most rational decisions hard to make. Fear can paralyze the most knowledgeable individuals given the right circumstances. After the 2007-2008 market collapse the market finally bottomed out around March 2009. Trophy businesses were trading at deep discounts but most investors were too scared to swoop in and capitalize on the opportunity.
Take a look at Starbucks during the last stock market collapse.
At the very bottom of the market crash Starbucks (SBUX) was trading for approximately $7.50! I just want to point out how insane that valuation is:
At $7.50 SBUX was trading for just 6 times free cash flow! Remember Free cash flow is the money from net income that’s actually real. It’s the money that’s actually available to you as an owner. It’s the money that’s left from the profits the company brings in after all of the capital expenditures are paid.
This valuation is incredibly insane, in short it means that if you had purchased Starbucks for $7.50 you would have paid 6 times free cash. A franchise like Starbucks typically sales for about 20-25 times free cash. That’s approximately a 75% discount on a major franchise. Truly a once in a lifetime opportunity!
Here is what Starbucks looks like today…
While it is sitting at approximately $75 today, Starbucks at one point was trading for approximately $80, literally 10 times its low of $7.50
The first thing an investor needs to have before investing a single dollar is a detailed purpose for why he or she is investing.
- Are you investing for retirement?
- Are you investing for wealth?
- Are you investing for your child’s college fund?
- Are you investing for income?
The answer to these questions will change your investment strategy completely because your overall goal is different. When entering an investment you need to take time, risk, and potential profitability into consideration. If you enter an investment without a clear cut purpose your chances of success decrease significantly. It would be the equivalent of hopping in your car at random and deciding to go on a cross country road trip without planning a single thing. Disaster is bound to happen!
Proper Valuation (Entry Point)
There are thousands of businesses in the United States and out of those thousands only a couple hundred are truly great businesses. However, just because a business dominates its industry does not mean it is a great investment all the time.
You may believe that a Honda Accord is the best mid class sedan ever made, but you would never pay premium price just to own a Honda Accord if you were a rational person, right? Chances are you would look to buy the car of your dreams at a discount or at the very least fair market value. Nobody in their right mind pays double or triple a car’s fair market value. Yet investors do it all the time with their investments.
Most novice investors overlook proper asset allocation. Most investors pile all of their capital into a couple of stocks then sit back and wait. This exposes their portfolios to massive amounts of risk because success and failure rides on the back of a handful of companies. When acquiring any type of asset it is imperative that you diversify and not place all your eggs in one basket.
If you were to own your own business chances are you would look to acquire multiple income streams and/or clients. If you failed to do this, losing one client or income stream could crush your business. The same principle applies to investing. Never forget that shares are actual pieces of the underlying stock and you should therefore treat stock investing like a business.
Stop Loss (Exit Strategy)
I will be the first to admit I’m not always right when it comes to my investment analysis. I believe I have a pretty good track record but nobody is perfect, not even Warren Buffet. This is why I recommend stop losses for every single investment you have.
What is a stop loss?
A stop loss order is set at a percentage level below the market price for a long stock position.
To use a stop you will predetermine a percentage below your entry price that you are willing to lose. This could be 10%, 15% or 25% whatever you determine this is your “pack up your bags and move on” price point. In other words, if the price falls below this price point it will set off an automatic trigger to sell.
Having a stop loss ensures that you take the emotion out of investing. No longer will you frantically check your account day in and day out thinking to yourself “Maybe today is the day this stock turns around.” If your stop loss is triggered simply sell the rest of your position and move on.
If you can apply these 4 fundamental investment principles you will have tremendously higher investment success rates and investment returns than your peers. Keep in mind that mastering these principles takes time but the sooner you start the easier it will be. Remember to take the emotion out of your investment decisions and replace it with rational and decisive decisions.
Do you currently implement any of these principles?