‘Play Safe’ – Rules of Stock Investing for 2012

Invest Safely in 2012Creating wealth through stocks isn’t as far-fetched an idea as it’s made out to be. Sure, investing in stocks is a bit of a game and involves some risk, but it’s also the best wealth creation tool if you master the art of playing it safe.

Those with a stock success story have gotten there by avoiding speculation and sticking it through. Following in their footsteps might require some patience and planning, but it doesn’t take a genius to multiply money through stocks. All one really needs to do is to pay attention to the basics. So here are a few basic rules one should keep in mind while investing in the New Year.

Be an Early Bird

Making money through stocks doesn’t happen overnight, it requires time and patience. They say that fortune favors the early bird and nothing is quite as true as with stocks. The earlier you start investing, the quicker that compounding interest begins to work its magic.

The rule of compounding interest is simple, the longer your money stays invested, the bigger the profit. So, investing at an early age is the key to maximizing your wealth! One of the best examples is the legendary investor, Warren Buffet who started investing at an age of just eleven!

Stick with what you know

One of Buffet’s basic rules is: If you don’t understand a company’s product or how it makes money, avoid it. And it is a good rule to stick with for every investor too. A good understanding of the company’s business might help to protect your investments better.

Choose a fundamentally sound company

Remember to always analyze the company’s financial strength, because only if the company is fundamentally strong can it weather the good and bad times alike! Checking the company’s financials will give confidence on its future growth. So, few of the parameters you can look for are companies with a strong CAGR growth in Net Sales and profits. Avoid companies with high debt and high working capital issues.

You can log on to MoneyWorks4me.com and check out the company’s 10 YEAR X-RAY which gives a quick snapshot about the company’s financial strength!

Take a Contrarian Approach

The herd mentality of investors triggers mass action often leading to mispricing in the market. A contrarian is one who chooses to buy or sell stocks when the bulk of investors seem to be doing the exact opposite.

When the price of a stock drops, people assume there’s trouble in the company and quickly opt out. A contrarian will buy at the lowest after judging a company not on the market sentiments, but rather on its fundamental strength. On the other hand, over enthusiasm about a stock leads to a hike in price and immediately more and more people want in. When others are going on a buying binge, a contrarian will end up selling the same. Equating a huge upsurge in price with the beginnings of a stock bubble bursting, they see it as the perfect time to get out.

Though deemed risky by some, contrarians like Warren Buffet have put this approach to investing right up there at the top. When the investing public is extremely negative, it’s usually a good time to buy stocks. When investors are overconfident, be careful. The current situation in the market could be such an opportunity for contrarian investors. Fears of a European Debt Crisis and domestic problems like inflation, high interest rates etc have resulted in quite a few stock being beaten down considerably.

Choose Large and Mid Caps

Companies differ from each other on the basis of market capitalization, which is the total value of a company’s outstanding shares. Companies are classified as Large, Mid and Small cap companies based on the size. Large cap companies are safer and offer a high liquidity. Though mid-cap stocks are more risky, one can always find a few robust stocks to invest in.

If you are an amateur investor, it would do well for you to stick to large cap companies to avoid losing any money. As your understanding improves, you can then move on to good mid-cap stocks to enhance your returns.

You can easily find out all the Large and Mid-cap companies in the BSE 500 List here.

Avoid Small Cap and Penny Stocks

Small cap stocks are the most risky to invest in. Mainly because of the little information available about them and the low liquidity they offer. Of course, one can always find a few good small cap stocks worth investing too! But if you are a low risk investor, it would be better for you to steer clear of the small caps altogether.

Also, many investors believe the lower the cost of a stock, the less the blow of the loss.  Though penny stocks can reap a hefty profit, they can also leave you with your entire capital being wiped away! The pros of penny stocks will always be far outnumbered by the cons.

There is usually not enough information on the finances of a penny stock company. Pegging your money on the mere hope of an outcome is not the smartest way to go. If the company fails to get back on track, you’d be left with a bunch of worthless stocks and no scope for growth.

Spread the Risk

  • Invest over time: Having a ton of money to spare doesn’t necessarily mean you should blow it all up at once. Always start with a small percentage of your piggy bank total and always spread out your investments over time. When a particular stock seems a great investment, it’s best to still be cautious – take it slow and add some extra money to your investment every few months.  This way, if it turns out to be a poor decision you’ll be able to get out with less of a loss. With the current situation especially, a stock which appears to be under-priced could drop further due to adverse market sentiments. You cannot predict the bottom, but investing over time will surely help you get your average buying price close to the bottom.
  • Diversify your portfolio: Every industry ends up experiencing some setbacks along the way. It could be caused by the weather, a global event or a change in government policies. Spreading your investments over various companies and sectors will avoid getting you caught with all your eggs in one basket.

Differentiate your Duds and Winners

As an investor, you will experience your fair share of both good and bad.  Of course if you’ve spread out your money sensibly, you should be able to take the blows and get back on your feet in no time. Knowing when to cut your losses and when to hang on is critical. If an investment continues in a downward spiral, it’s a good time to sell out. If however the business shows signs of getting back on track, it’s worth waiting it out a while. The discipline of deciding a stop loss is a good way to go about this. If you feel the growth story of the stock is intact, you can always reinvest at a lower price! This will help limit your losses at a minimum.

Don’t Panic!

At the end of the day the most important thing is to keep calm and collected. You’ll have your hits and misses with stocks, but if you keep your eye on the market trends and stick with the safety guide, you can weather any storm.

So keep these rules in mind the next time you invest and you’re sure to do better! You can also read our Timeless principles of Stock Investing for further reading on safe stock investing.

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3 Responses to “‘Play Safe’ – Rules of Stock Investing for 2012”

  1. Investing first 3-6 months in DEBT market while rest months in STOCKS.

    Also having stock specific approach from the beginning of 2012. 

  2. Fruitful indeed!!!!!!! Cheers 2012    …gupta.rajiv@ymail.com

  3. Excellent informative article