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7 rules to become a great investor

Last updated on: August 18, 2010 10:11 IST

7 rules to become a great investor

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Generally, savvy investors have certain traits in common and have learned how to handle markets in all their variety. Check out what it takes to be a great investor...

A great investor understands risk

Understanding risk is essential to developing an investment strategy that works and produces repeatable performance over time.

As individuals, we need to be aware of the times we are irrational in our thinking about investing.

By clearly understanding the potential for loss, investors can allocate their funds among long-term, mid-term, and short-term investments.

With longer horizons before the funds are needed, a higher portion can be allocated to equities.

With short-term money, the options are far fewer and are primarily money markets, short Treasuries, and low-duration bond funds.

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Great investors understand how emotions influence investment decisions

A great investor has a plan, is disciplined, does not get caught up in either irrational exuberance on the upside or irrational panic on the downside.

Great investors do not allow their decisions to be ruled by emotions.

The field of behavioral finance gives us some good insights into the most common mistakes people make and how to avoid them.

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Great investors diversify across asset classes and industry sectors

A well-diversified portfolio includes large-company, mid-size, and small-company stocks. Both value and growth styles are reflected, as well as domestic and foreign stocks.

Generally, you will overweight large cap investments, as they tend to have lower-risks than do mid- or small-cap stocks.

Research shows quite clearly that an equal weighting between value and growth styles of investing produces better returns over a longer period than does each style alone.

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Rebalance only periodically

Once you have your diversification model set up, it is important to stay the course.

There will be times when you will feel you've erred as one style (value or growth), or one asset class (large cap or small cap) outshines the other.

The temptation is to add funds to the outperforming investment, or at the very least to let your winners run and sell your losers.

Rather than doing either of these, the strategy that produces the best returns is to rebalance your portfolio yearly.

Reducing your winners to add to your losers on an annual basis produces very good results over the long term.

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The importance of staying invested

Besides rebalancing, you'll want to stay invested.

It's difficult, if not impossible, to time the market. So whatever portion you decide to put into equities should stay unless something changes in your personal situation requiring that you have less volatility and more income.

Statistics show that over time it is more effective to stay the course.

Since most returns come in a relatively few days each year, staying invested shows better returns than if you move in and out of the market and happen to miss the select few days of great market performance.

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Go for GARP (growth at a reasonable price)

Picking the right stock is not an easy process. You'll have better success if you have clearly thought through the criteria you'll use for buying, as well as for selling.

You need to have some drug stocks, some financial stocks, some technology stocks, and some consumer cyclicals.

You need a broad range of stocks, as is offered in the S&P 500.

This gives you some industry underweights and overweights because we think we can add value to our stock picks.

So in terms of choosing stocks, we look at trends: What are the drivers in the industry doing? What is their earnings growth? We also do a fundamental analysis by looking at cash flow and employing the PEG ratio.

The PEG ratio is price divided by earnings, divided by growth. You want to buy stocks that have a PEG ratio of less than two.

If a stock has a P/E ratio of 20 and is growing at 20 per cent per year, it has a PEG ratio of one.

Suppose now that the P/E ratio is 40, and its earnings are only growing 10 per cent per year. It will have a PEG ratio of 4. That stock is too highly priced. I believe earnings growth drives the stock selection process.

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Great investors understanding how investing is different now

There have been more changes in the first few years of the 21st century than in the 20 previous years put together. The environment is different for investors, for various reasons.

  • Information is everywhere and easy to get. A grandmother in Nebraska with a computer can have access to the same analytical information that used to be available only to the top money managers. Access to the Internet also levels the playing field between men and women. Women are now logging on at a greater rate than men are and have become active investors.
  • Transaction costs have declined so that they are almost negligible. The trend is away from commissions and toward fee-only money management. The competition is fierce as large brokerages, banks, and insurance companies embrace this new business model.
  • The media influence investment decisions. You probably remember, as I do, that TV spot with the truck driver who owns an island. It is implied that his success is attributable to his discount brokerage account. What it shows is that anyone can be an expert. The media's message to America is all you need is a mouse and a pulse to be a stock market success. Sadly, the general investing public figures out only slowly that it's not quite that easy.

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  • Time frames have collapsed. In the past, when we talked of long-term investing, it was five to 10 years or longer.

  • Now people think long term is two to three years. In my mind this phenomenon contributes substantially to the next point.

  • Volatility more than ever before is here, and it's here to stay. Investors often act before they think and before they have all the information they need to make appropriate decisions.

Simply put, the best approach is to be diversified and not try to time the market. Have patience, and focus on the long term.

It has been said that investing in the markets is like riding an up escalator with a yo-yo.

The long-term trend is upward, and the movements of the yo-yo up and down represent the day-to-day fluctuations.

The short-term volatility we experience in today's markets is not meaningful when compared with longer-term trends.

Successful investors take advantage of volatility: They diversify their portfolios to reduce risk of loss; they set clear buy and sell criteria; and they stay disciplined and focused on the long term.


[Excerpt from Profitable Investing in Volatile Markets. Published by Vision Books.]

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