The key to making money in the stock market is invest for the
long-term, buying only undervalued stocks which, to quote Benjamin
Graham, have a "Margin Of Safety". Ben Graham and Warren Buffett
both made enormous fortunes through long-term value investing. Indeed, Buffett continues to do so and has averaged over 22% average compounded annual gains over a 39 year period.
These results are phenomenal and not easy to emulate. However, with time on your side and a little bit of work it is possible to do nearly as well as Buffett.
Even if you beat the S&P 500's average long term return of around 11%, you are doing very well indeed.
Suppose you invest $3,000 in a Roth IRA or other tax-efficient retirement account every year for 20 years and achieve an average annual compounded gain of 11% over that period. At the end of the 20 year period you could have around $238,000 disregarding dealing costs and dividends. You have only invested $60,000 - so $178,000 is generated entirely through compound interest. If you were to emulate
Buffett's 22%, that $60k would become $1,031,000. If you were to start earlier and invest $3,000 a year for 40 years at 11%, you would end up with $2,132,483. Match Buffett's 22% on these investments over 40 years and you may wind up with a whopping $55,000,000, for an investment of $120,000! That is the power of compound interest.
Many people ask me "Which stocks do I buy?" and "How do I start?" They keep making excuses NOT to start investing for the long-term. My advice is a bit like a Nike commercial: JUST DO IT! Get started. Open a Roth IRA, start by putting money in regularly, even if it's only $25/month. It's important to get into the HABIT of regular savings. In the meantime you can worry about which stocks to buy.
Picking stocks to buy is not actually that hard. It should not take a great deal of work. There are lots of places you can look for investment ideas: in fact there are hundreds of investing websites, including The Graham Investor where we tend to profile stocks that come up in value-based screens and give an opinion as to why a particular may be worth following - not necessarily buying.
There are many different strategies to take; a typical one is to first screen for stocks that meet a particular value criterion which might be any one of: a low PEG, high intrinsic value when compared to current price, price below two-thirds of the Graham Number. Once we have a list of suitable stocks meeting the basic criterion, we can filter
out stocks with poor cash flow, excessive debt, poor earnings, or insignificant anticipated growth. We also avoid stocks with low liquidity by making sure average daily volume is as high as possible, and stocks with low prices (typically steering clear of stocks trading at less than $3).
Once the additional criteria are met, look at the charts for each stock. Look for a recent clear downtrend or new 52-week low. Put the stocks with a most obvious downtrend onto a watch list. In particular watch those where the downtrend also shows declining volume. Look at the news for these stocks to see if there is an obvious reason for their recent poor performance. Do not buy - they could go down more. We don't want to try to catch the bottom; it's a sure way to lose money. What we are watching for is a clear sign of a reversal and buy as the stock moves up. Often a reversal can take place slowly and imperceptibly, other times it can be an abrupt reversal. Most
often it is somewhere in between. Perhaps the stock has been beaten down by investor sentiment in the form of an overreaction to bad news. At some point the bad news may be dispelled or proven to be unfounded, and the stock will begin to return to fair value.
Or, some good news may come in and the stock reverses as investor sentiment comes in. Typically when this happens, we want to see the downtrend broken convincingly and the price rising on increasing volume.
How do we know if the downtrend has broken? Simply draw a line joining the high points in the downtrend, and wait for that line to be broken to the upside with significant volume. What is significant volume? It depends. The higher the volume the better. Look for at least 150% of the average daily volume.
Once you have bought, set a stop loss order around 8-10% below where you bought. If at all possible, set the stop loss order just below the lowest low point before the reversal, so long as it's not too far away from your entry. Spreading your risk can help minimize losses. Divide your equity into at least 10 lots; if you have $5,000 to invest only buy $500 worth of each stock and keep your stop loss 10% of that, or $50. If the logical stop loss point is too far from your possible entry point, don't invest. Stick to the rules and cut your losses short. Let your profits run. In the long run you will make much more on the winners than you lose on the losers -- you can have 5 losers and still be down only $250 or 5% of your equity.
Buying undervalued stocks with good fundamentals in this way at or near low points when nobody else has been interested for a while but there are signs of a reversal is possibly one of the least risky investment techniques because of the built-in "Margin Of Safety".
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Making Money with Stockmarket
