Investing has a lot in common with sports. There is competition, there is money to be made for the winners – and there are rules to follow.
But in investing, unlike boxing or mixed martial arts, the most important rules are the ones that you write for yourself. The right rules not only protect you from getting hurt but also help you win.
I'd like to share a few of my rules with you. I'm not telling you to follow all of them (or any of them), but try them on and see how they feel.
1. Buy for the long haul
I expect to hold most stocks for many years. Perhaps decades.
Sure, it's easier to commit to long holding periods when you're buying into an established, stable business, such as Coca Cola or McDonald's. But even in the fast-moving technology sector, you should buy only when you're convinced that you're picking a long-term winner.
Thinking this way forces you to be more than a casual gambler. If you realize you made a bad decision, you can back out. But I prefer to pick stocks where I have no intention of backing out.
2. Understand risk
If you study finance, you'll be taught that risk is related to how volatile a stock price is. For long-term investors, though, volatility is meaningless.
As finance professors will tell you, volatility is a calculation of how much a stock tends to move in proportion to the overall market. It's expressed as a ratio called "beta." High beta stocks have more risk of dropping in a weak market than most other shares, but they also carry more reward in a rising market.
As a long-term investor, who cares? Short-term volatility has no bearing on long-term results.
Mutual fund managers care about beta because they have to report annual returns to the public. They can't risk underperforming too badly in the short term. It wouldn't make for good marketing material.
But as an individual investor with a long-term horizon, you shouldn't concern yourself with one-year performance. Focus on buying quality businesses and ignore stock market gyrations.
3. Know when to sell
You should sell only when your reasons for owning a stock are no longer true.
This simple rule forces you to go into an investment with a well articulated set of reasons. Over time, the reasons will either prove accurate or not. If they are accurate, you hold; if not, you sell.
In my Strategy Lab portfolio, I own Netflix, the distributor of streamed video and DVDs. It has had a volatile ride over the past couple of years and many investors have fled the stock.
With Netflix, I'm betting the company can profitably expand into new markets. I'm betting that people will dump their cable TV connections over the next decade. I'm betting that Netflix, as a global business, will be more relevant than any local (or national) cable TV operation.
I'll look at Netflix's quarterly results, of course. But rather than dwelling on whether the company is meeting Wall Street's latest forecast, I'll be asking myself: Is my investment theory proving to be correct, or is it totally wrong?
Until something changes my mind about the long-term outlook for the business, I'm prepared to ride out the ups and downs.
I'm passionate about growth investing – but there are thousands of potential growth stocks to choose from. I'll only buy a stock that I understand well and have an interest in following.
This poses a problem if I don't see enough compelling ideas. In cases like that, I diversify my portfolio by either holding exchange-traded funds that track broad market indexes, or by buying more stable businesses.
Never stick your money into low-quality ideas just because you label yourself a growth investor.
5. Stay invested
Everyone has to decide for themselves just how much cash they need to keep on hand. Beyond that point, I believe you should stay invested in the market. Over the long term, the stock market rises faster than inflation. If you aren't invested, you're losing money.
I don't believe that I can time the market, so I won't sell stocks because I think a correction is coming. I prefer to stay invested – for decades.
If that means investing in the index while I search for the next great stock, so be it. I'll be taking my own advice in Strategy Lab. The cash in my portfolio will either go into another stock, or the index.
Securities mentioned in this article: