Basic Investing Principles

**Disclaimer:** The views below represent my opinions. These investment principles do not constitute investment advice, but rather are general principles one might employ in reaching his or her overall financial goals. *All* investing bears risk, including possible loss of capital. I am NOT a financial advisor or registered securities analyst.

Below is a list of basic investing principles that I’ve learned over the years, either through trial and error or through research. I believe the following principles are a good foundation for investing, especially if you choose to invest in individual stocks:

Diversify. Diversify. Diversify. I can’t stress this enough. It’s true that you can’t just save your way to financial security, you have to invest. But you also can’t just play offense, you have to play defense as well. You have to protect your investments and minimize loss of capital as best as you can. The best way to do this is to diversify your assets. And when I say diversify, I don’t mean diversifying by investing in different industries within the US. You need to invest in more than just US stocks. You should at minimum be invested in US stocks, international stocks, bonds, and real estate index funds (REITs). If you want to hedge your portfolio against volatile markets even more, you can invest in gold. If you can afford to be a little more aggressive and riskier, invest a small amount in Crypto and individual companies. The goal is to select an asset allocation that lets you sleep at night and helps you avoid the urge to sell in a panic the next time the market tanks. One of the greatest teachers of investing, Benjamin Graham, had a rule of thumb: 100 – your age = risky assets (such as stocks), with the balance in less risky assets (bonds, gold, cash). Everyone’s goals and situations are different. I’m not here to tell you what percentage you should be invested in each asset. You have to figure that out and do what works best for you but diversifying and using Graham’s rule of thumb is a good starting point.

ETF’s versus index funds. Both are mutual funds. The only major difference is ETF’s are traded throughout the day like stocks, whereas index funds are bought and sold at the price set at the end of the trading day. Not a big deal if you’re not a day trader. One difference that might matter more to you though is that ETF’s tend to have a much lower minimum investment requirement compared to index funds. You really can’t go wrong with either because both tend to have low expense ratios (fees).

REIT’s belong in tax protected accounts like Roth IRA’s. REIT’s are very tax-inefficient because of their dividends. Most dividends are classified as “qualified dividends”, which means they’re taxed at the same rate as long-term capital gains. Whereas REIT dividends are taxed at the higher ordinary income tax rate. Let’s say you’re single and you make $80,000 per year. If you owned stock in a company that paid a dividend, you would pay a 15% tax on receiving that dividend. But if you owned a REIT, you would pay a 22% tax on that dividend! Therefore, REIT’s belong in a tax-protected account like a Roth IRA that allows those dividends to compound over the years without you having to pay taxes when you eventually withdraw from your Roth at the age of 59^1/2 .

Dollar cost averaging Index Funds. According to Investopedia, dollar cost averaging is “the practice of systematically investing equal amounts, spaced out over regular intervals, regardless of price.” It’s the same principle as contributing to a 401K. Investing into a fund every month, regardless of price, and whether it’s a bear market or bull market. No one can time the market. If you think the market’s due for a crash and you decide to stop investing so you can time it perfectly, you might be sitting on the sidelines with your thumb up your ass for years, missing out on significant returns. I’ve been investing since 2015. I’ve been hearing that there’s a bubble for 6 years. And look, most likely we’re in one. But that shouldn’t stop you from investing because historically the market averages a positive return on your investment annually. You have to keep yourself in the game. You buy more, whether the markets have gone up, down, or sideways. Ideal way is to dollar cost average into a portfolio of index funds. If you have a 3-fund portfolio and you have $500 a month to invest, you can dollar cost average monthly by putting $300 into the total US stock market index fund, $100 into the total international stock market index fund, and $100 into the total bond market index fund.

Pay attention to fees. When you’re looking at index funds / ETF’s, pay attention to the “expense ratio,” which is a measure of the mutual fund’s operating costs to its assets. The higher the expense ratio, the more you pay in fees, which cuts into your return. If a fund’s expense ratio is 0.05%, you would pay $5 per year in fees for every $10,000 invested. If an expense ratio is 0.75%, you would pay $75 in fees per year, for every $10,000 invested. That’s a huge difference. It may not seem like much, but over time as your investments compound, so will the amount you had to pay in fees. Remember, the market averages an annual return of 7%. Every percentage point matters in the long run. Of all of my Vanguard index funds, the highest expense ratio is 0.12. I really would stay clear of funds with an expense ratio higher than 0.50. There’s plenty of good index funds / ETF’s with expense ratios lower than this.

DRIP (Dividend Reinvestment Plan). When you purchase stocks that pay dividends, you have the option to either reinvest those dividends to buy back additional shares (or fractional shares) or accept the dividend in cash. On individual stocks that I plan on being invested in indefinitely (Apple), I reinvest my dividends. If my index funds pay a dividend, I reinvest. If it’s a bond index fund or a stock that I’m only holding short-term, typically I’ll just accept the dividend as cash to use to purchase additional stocks/funds in the future. I’ve also used the cash from these dividends to pay for vacations.

Always do limit orders instead of market orders when selling stocks, specifically for short-term trades. A market order tells the broker to buy or sell at the best price they can get in the market, and the trades are usually executed immediately. A limit order means you can set the maximum price you are willing to pay for a stock, or a minimum price you’d be willing to sell a stock for. If the stock is trading anywhere below your maximum purchase price, or above the minimum selling price, the trade will be executed. I use a limit order to protect my profits. As soon as I purchase a stock on eTrade or Ally Invest, I use a limit order to sell at a price target I believe it will reach that will provide me a healthy profit. For example, I purchased a stock recently for $12 / share that I believe will reach $16. As soon as I purchased the stock I set a limit order to sell the stock when it reaches $16 / share. The stock will be sold only if it reaches that set price. Once you set the price it’s all automated. That way I don’t have to keep checking my portfolio every day, and protects me if I miss when the stock actually reaches that set price.

Short-term capital gains (profits) are taxed at a higher rate than long-term capital gains. If you hold a stock for less than a year and sell it for a profit, it’s considered a short-term capital gain. If you hold a stock for longer than a year and sell it for a profit, it’s considered a long-term capital gain. Short-term gains are taxed at your income tax rate (rates range from 12% to 37%) and long-term gains are taxed at the following:

0% capital gains rate for income up to $40,000 for single filers and up to $80,000 for joint filers
15% capital gains rate for income between $40,000 and $441,450 for single filers, and for income between $80,000 and $496,600 for joint filers
20% capital gains rate for income over $441,450 for single filers and for income over $496,600 for joint filers

Sell your losers to offset paying taxes for your winners. You can reduce your tax bill and offset capital gains by selling up to $3000 in capital losses, annually. You can carry losses above the $3,000 threshold over to subsequent years. Let’s say you sold Apple stock and profited $5,000. Instead of paying capital gains tax on that $5000 profit, you sold a stock that you’ve been wanting to get rid of and took a $3,000 loss. That $3000 loss would offset $3000 in profit and you would only owe capital gains taxes on $2000. However, there is a catch. The IRS has a wash-sale rule which says you cannot claim a loss if you purchase substantially identical securities 30 days before or after the sale.

Rule of 72. A rule of thumb used to estimate the number of years required to double your money at a given annual rate of return. T = 72 / r, where T = the number of years and r = the rate of return. If I received a 10% annual rate of return on an investment, I would double my money in 7.2 years (72/10 = 7.2).

Learn to read the following:

Income statement
Balance Sheet
Statement of Cash Flows

Morningstar.com offers a great course on the basics of how to read each of these. These three financial statements provide key insight into how a company is performing and whether you should invest in a company. They also throw significant light on the number that Wall Street pays most attention to, reported earnings.
If you use eTrade as your broker, you can find each of these under the “Fundamentals” section of the particular company you searched for.

Buffet’s 4 rules for investing (All 4 rules must be met before a stock can be purchased):

Stock must be stable & understandable.

Only invest in what you understand. And you can’t invest in a company whose debt fluctuates and whose earnings do not consistently grow. Look at the company’s debt to equity ratio and earnings per share of the past 10 years. You want a company whose debt has been stable or has been decreasing and its earnings per share has been growing or has been consistent.

Stock must have long term prospects.

Will the company be irrelevant in 10 years? Does the company make a product that will always be bought or does the company have a good track record with adapting with the times? Buffett is not a day trader. He buys stock to hold onto for years.

Stock must be managed by vigilant leaders.

Vigilant leaders do NOT take on a lot of debt. This can quickly get a company in trouble, as evidenced by the Pandemic. Airlines are a good example. The ones that had a lot of debt needed a government bailout to stay afloat whereas a company like Southwest didn’t need a government bailout to survive and had enough cash on hand to keep them afloat. Two key metrics for assessing a company’s debt are the debt/equity ratio and the current ratio. Buffett likes a debt/equity ratio < 0.50 (If a company has a debt/equity ratio > 1 than they have more debt than assets which is no bueno) and a current ratio of > 1.5 (can the company pay off its short-term debt in the next 12 months – current assets / current liabilities).

Stock must be undervalued.

This is where you calculate the intrinsic value of a company, which is discussed in the next principle. If you found a company that meets the first 3 rules and has an intrinsic value greater than its stock price, you just found yourself a company to invest in. “Price is what you pay. Value is what you get.” – Ben Graham

Value investing. I learned how to calculate intrinsic value on buffetsbooks.com. The basic idea is that you can calculate what a stock is truly worth using past data (dividends and book value) to predict future growth. The fundamentals tell you what stocks to buy and calculating the intrinsic value tells you when to buy a stock. If the intrinsic value is greater than the stock price, it’s a buy. If the intrinsic value is lower than the stock price, then you wait to buy the stock until the stock price drops below the intrinsic value. Book value is a key metric to calculating a company’s intrinsic value. Book Value (BV) is a company’s assets minus its liabilities. It reveals the current state of the company and how much the company is worth if liquidated and sold for cash. Book value per share is simply the book value (assets – liabilities) divided by the number of shares. A key metric that Buffett loves is the P/BV ratio, the price of a share of stock / book value per share of stock. Buffett prefers a P/BV ratio of 1.5 and lower.

Make a stock watch list. Identify stocks that pass the fundamentals but are overpriced. Then wait until their stock prices drop below their intrinsic value and buy at a discount.

Practice investing in individual stocks using a simulator.

Copy great investors. Use dataroma.com to see what investors like Warren Buffett and Carl Icahn are investing in. One time I was looking for a REIT to invest in short term and discovered that Buffett had holdings in STOR. After doing more research I determined it was a smart purchase and I ended up making a 20% return in a matter of months.

Don’t invest in too many individual stocks at once. You do not want excessive diversification for your individual stock portfolio. I would say no more than 20 stocks at one time. This isn’t a passive investment like index funds where you invest and forget about it. While you don’t want to monitor your stocks every day, you should at least monitor them every couple of months.

Only a small portion of your portfolio should be spent on speculative stocks. Speculation is the intuition that a stock will do well but it’s not based on anything tangible. I have a few in my eTrade account. Mainly space and electric vehicle stocks. Companies that have the potential to skyrocket if those 2 industries take off in the future. Only risk money in speculation than you can afford to lose.

Price of a stock does not matter, if the price is below the intrinsic value. I know this sounds crazy. And it’s against human nature to not care about the price of something you’re buying. When I first started investing six years ago, I balked at purchasing Google stock because it was $500 per share. $500 PER SHARE!!! Now it’s $2700 per share!!! Stock price does not mean shit. Google is a financially healthy company. It’s constantly beating earnings. It has very little debt. It has a P/E ratio of 29.99 (discussed in the next principle) which compared to its technology peers, is pretty, pretty, pretty good. Which means it’s not overvalued. Now imagine you’re trying to choose between buying stock in Google, and buying stock in another company whose stock is only $100 per share, but has more debt, and its future earnings are projected to be less than Google. Human psychology would tell us that Google is already at $500 per share, how much higher can it go? This other company is only $100 per share and has more room to grow in price. This is exactly how I used to think when I first started investing. Completely wrong. Don’t fixate on a company’s stock price.

Set rules for when to sell, such as a profit goal or loss limit. If I see a stock that has a 10% upside then selling for a 10% return is my rule for that specific stock. I did this recently with Wal-Mart. For other stocks that I will only hold for short term, I’ll sell when I reach a 20% return. For longer term investments that are doing extremely well, I’ve sold enough shares to recoup my initial investment and the rest is house money. I used this approach with Square. I bought 150 shares @ $14/share and when I doubled my money ($28/share), I sold half of my shares to recoup my initial investment. To this day I have 75 shares valued at $270 per share!!! You can have a uniform selling policy for all of your investments to make it easier or adopt an approach similar to mine. When you institute rules for selling, it’s easier to stick to and removes the emotion out of investing. Most brokers make it very easy to set “stop losses” or sell at a predetermined price.

Do NOT look at your investments every day. This can lead to poor decisions and is what led me to selling Netflix prematurely. I bought Netflix and preceded to look at the stock EVERYDAY. It could go down $10 a share and I would be nervous. In the end, I sold it after a couple months for a profit of $5 a share. If I would have hung onto the stock I would have made 6x my initial investment. “In the end, how your investments behave is much less important than how you behave.” – Benjamin Graham. Markets will inevitably decline. Remember how much the market tanked early last year because of the Pandemic? It only took less than a year for the market to recover and surpass its previous high. You’re better off monitoring your accounts quarterly.

Don’t overreact to the news. Because the market absolutely will. In July of 2019 Facebook was fined $5 billion by the FTC due to its privacy violations. The stock preceded to drop from an all-time high of $207 in July all the way down to $124, where it bottomed out in December of that year. Since then, the stock has tripled and as of this post is at $358 per share. A $5 billion fine hurt. But the market overreacted, fearing people would permanently boycott the company. They didn’t. If you were patient or knew that markets overreact to the news, you would have made a lot of money. Markets tend to overcorrect during negative news cycles.

Buy when there is a market correction. A correction is typically when the overall market suffers a decline of 10% or more from its most recent peak. The average market correction is a decline of 13% and recovers after four months. There have been 38 corrections since 1950. All but 10 of these corrections transitioned back to bull markets. One of the most recent corrections was in December of 2018. The S&P 500 fell 15%. I immediately bought more stock of the Vanguard Total Stock Market Index Fund and Apple and by April of 2019 the market had recovered all of its losses and was up 20% since the correction started.

Be patient grasshopper. “Patience is an investor’s single most powerful ally.” – Benjamin Graham. When markets are panicking and you don’t know what to do, do nothing. Don’t make rash decisions. When Warren Buffett was 11 he bought his first stock, 6 shares of Cities Service @ $38 per share. The price fell to $27 but soon went to $40 and he sold. However, the stock shot up to $202 a few years later and he later cited this experience as an early lesson in patience in investing.

Don’t get too greedy. Make enough money to meet your own needs. “Bears make money, bulls make money, and pigs get slaughtered. – Jim Cramer” – Broke-Traveler

“Be greedy when others are fearful, be fearful when others are greedy.” – Warren Buffett. Market corrections are like Christmas morning for me. When everyone is panicking and selling, I’m buying stocks on discount with my opportunity fund. And when markets get out of whack, I sell off some investments and take my profits, padding my opportunity fund for corrections that are just around the corner.

Don’t jump on the “hot” investment bandwagon. If the stock is front-page news, 9 times out of 10 it’s too late. Case in point, Game Stop. If you got in before it hit triple digits, congratulations (Not really, I’m still salty). By the time I got in, it was north of $300 per share. Once I heard my coworkers talking about it, whom I have never heard talk about stocks before, I knew it was too late. Don’t follow the herd.

Buy the rumor, sell the news. This is a great short-term play. When you hear a rumor that a company might acquire another company, a company might release a new product, or a company might announce a stock split (Usually attracts investors because psychologically it’s more valuable to own more shares of a stock even though the price was adjusted to reflect that split), you buy the stock and wait for others to do the same, which will drive the stock price higher. Then right before the actual announcement, you sell, reaping the profits. A recent example of this is was when the rumor started that Churchill Capital (SPAC – special purpose acquisition company) was going to buy Lucid Motors. The stock doubled from $30 to $60 per share in a matter of a week. If you had realized this tactic, you could have doubled your money in 1 weeks’ time!!

Hunt for bargains. Look for large companies that have fallen out of favor with the market and are going through a period of unpopularity, usually because of disappointing earnings or a controversy, and because of that, are undervalued. But large enough that they have enough capital and good leadership to get them through the adversity. Graham defines a true bargain as a company that is currently trading at a 50% or more discount from its inherent/intrinsic value. I recently purchased Walmart stock because it was valued less than its intrinsic value. There is nothing fundamentally wrong with the company but because its growth is not on par with its rival Amazon, its stock price was dinged. I took this opportunity and purchased it at $130 per share and sold at $145.

This article is for informational purposes only. It should not be considered financial or legal advice. Consult a financial professional before making any significant financial decisions.

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