10 Principles for the Common Sense Investor
Copyright 2006 Quentin James
1. Put Your Money To Work
Investing is about putting money to work in effective ways to
make more money. The most effective way to put your money to
work over the long term is in well-run, profitable companies.
Companies that are good stewards of your money, will help you
create a level of wealth that you couldn't generate by merely
saving your money.
2. Investing is not a Game
Many people mistakenly think of investing in the same way they
think of sports or gambling: as a game. Watch CNBC for a day and
you'll see what we mean. The ups the downs, the highs the lows.
The stock market, over the short-term, can provide entertainment
value and adrenaline rush.
But investing is not a game. Your goal is to make more money,
and it turns out that over the long-term, there are intelligent
and rational strategies for growing your money. The reason you
make money should actually make sense!
Remember: don't treat investing as a game of chance.
Understanding why your investment makes you money is the key to
being a common sense investor.
3. Risk is relative
It is not uncommon for financial advisers to give very bad
advice. One of the most common pieces of bad advice is the view
that saving your money in something like a CD is less risky than
investing it in stock equities. Why is this not true (most of
the time)? Because history tells us that risk is relative. Over
a 15 year period of time it is clearly more risky to leave money
in a CD than in good stock. While your balance won't erode, the
purchasing power of your money could due to inflation and taxes.
Over periods of time that are greater than three years, the
common sense investor understands that, ceteris paribus, the
best place for money is in stocks.
4. Invest in Good Companies, Avoid Bad Companies
The common sense investor entrusts his money in companies that
put money to good use. Good companies will use money in
effective ways to produce more wealth. One of the best ways to
identify good companies is to look at their Return on Equity,
which is essentially a measure of how well they create profits
using shareholder investments.
5. Don't Pay Too Much For a Good Thing
Even if you've found a good company, don't invest in the company
unless it's being sold at a reasonable price. Ideally, try to
find good companies that are selling at a discount. Often times,
you will have to go against the flow and buy into companies that
are out of favor for one reason or another (often irrational)
with investing professionals. Normally, a company is priced too
high if it's Price To Earnings ratio is higher than its Return
on Equity.
6. Fear the Following of Fads
Following the crowd can be disastrous for the common sense
investor. More often than not, it results in paying way more
than a company is worth. If the price of a company is dictated
by short-term exuberance rather than long-term rationality, it
should be avoided.
In fact, the common sense investor can take advantage of the
fact that in the short term, stock market exuberance is often
irrational. If the boys on Wall Street are too extreme in a
sell-off for a good company, you should be ready to buy.
7. Time is on Your Side: the power of compounding interest
Give your money as much time to grow as possible. If your money
doubled every five years, then five thousand dollars would turn
into $320,000 in thirty years. Over 10 years, it would only turn
into $20,000. Big difference.
It seems like magic, but it's not. The earlier you put your
money to work, the longer it works for you, and the more wealth
you generate. It makes a lot of sense if you think about it.
Wealth is generated via production. The longer your money works
in good companies, the more time it has to produce further
profit; profit which you get to share. The cool thing is that
you can put all of your profit back to work, and effectively
have more money generating more profit. This process can keep
iterating so long as you don't withdraw your money.
8. Some Debt is Good Debt, But Most Debt is Bad
Why pay off a debt that is accruing a 5% tax-deductible interest
when you could be generating 12% interest by investing your
money instead? Many people make the mistake of trying to pay
down their home mortgage early, but this is often unadvisable
for several reasons. First of all, the money you pay towards
your mortgage is not liquid and gets tied up in your home until
you sell. Second, mortgage is often tax-deductible. You can't
take advantage of this tax break if you avoid the interest.
Having said that, most debt should be avoided. Never sustain
credit card debt and try to avoid all debt that will be used to
purchase items that depreciate (e.g. cars, clothes, toys). Debt
can be emotionally and psychologically difficult to sustain so
only carry good debt if it doesn't affect you aversely.
9. Keep It Simple
Always, always, always understand your investments. Understand
the company's business model: how they make money. If the
business model seems odd (read: Enron) or complicated or
unfocused, avoid the company, even if it means that you have to
avoid the temptation of following the crowd.
Companies make money by producing products and services that
people or businesses want and need. Make sure you understand
what products and services your company are producing and
developing for profit.
10. Employ Disciplined Principles
Invest regularly and intentionally. Force yourself to put your
money to work, but don't just throw your money at any
investment. Choose your investments wisely. Don't chase after
fads. Fight your emotions. If you feel like selling (the market
is doing badly), you should probably consider buying and if you
feel like buying (the market is doing well), you should probably
consider selling.