This list will provide you with some of the most popular and highly regarded investment books of all time. They will provide you with knowledge that will help you to invest with confidence. You will learn how Warren Buffett achieved average annual returns of 20.9% versus 9.9% for the market over a 50 year period. You will also learn how Benjamin Graham was able to achieve returns of 14.7% annually versus 12.2% for the market as a whole from 1936-1956 and much more.
Many of these books are dated. However, their principles and strategies remain relevant today. I have personally read all the books listed. I would not allow myself to provide you with a book recommendation without personally evaluating and assessing each book and the value contained within. We will begin with my favorite book, by Benjamin Graham.
Book #1: The Intelligent Investor: The Definitive Book On Value Investing
Author: Benjamin Graham
The Intelligent Investor is widely regarded as one of the best investing books of all time. Despite its original 1949 publish date, the information contained within is still relevant today. To quote Warren Buffett, it is “By far the best book on investing ever written.” This book covers areas of investing including: The past century of stock market history, general portfolio policies to follow, how you should interpret market fluctuations and much more. It provided me with the knowledge needed to independently select stocks with confidence.
As the name of the book would suggest, Graham employed a value investing approach. He pursued stocks which he believed were worth more than their current market quotation would suggest. Essentially, he would buy stocks trading at $0.50 that he believed had an intrinsic value of $1.00. This strategy awarded him with above average returns over his career (as discussed below), while providing safety of principle for himself and his clients.
Benjamin Graham, the author, was an extraordinary person. He attended Colombia Business School on a scholarship. (Colombia Business School currently holds the #7 position worldwide for its MBA program). Graham graduated from Colombia as the salutatorian of the class at the young age of 20.
As mentioned previously, he gained at least 14.7% annually for his clients versus 12.2% for the overall stock market. This became known as one of the best long-term track records in history. Warren Buffett, one of Graham’s most successful students, originally developed his investment philosophy around the principles Graham advised. Here is a resource for more information about how to invest like Graham.
The Warren Buffett Way provides an insight into Buffett’s investment techniques and practices. It is a great read and if you would like to learn more about Warren Buffett and his investment methodology, there is no better place to look. Originally published in 1994, it contains updated accounts to ensure the contents remain relevant today.
Containing forewords from some of the greatest investors of all time, this is an essential book for new investors. That list includes Howard Marks, co-founder of Oaktree Capital Management (a global asset management firm with over US$122 billion in assets under management) and Peter Lynch, former mutual fund manager and philanthropist who averaged returns of 29.2% annually between 1977 and 1990.
The Warren Buffet Way is a comprehensive investment resource and Hagstrom has provided us with an in-depth insight into Buffett’s investment career. It details how he was able to turn $100 in 1957 into a personal net worth of over $80 billion today. Buffett is known for his impressive record of returns throughout his investment career. From 1964-2017, his holding company, Berkshire Hathaway, achieved average annual returns of 20.9%. Versus 9.9% (including dividends) for the S&P 500.
Hagstrom has provided us with an in-depth insight into some of Buffett’s largest and most significant investments and their outcomes. Companies such Coca-Cola and The Washington Post are included. Hagstrom has also explored less common areas of investing, including behavioral finance and the mathematics of focus investing.
The Warren Buffett Way will give you an insight into the techniques and strategies employed by one of the most successful stock market investors of all time.
The author, Robert G. Hagstrom, is the chief investment strategist and managing director for Legg Mason Investment Counsel. He has also authored other investment books including “Investing: The Last Liberal Art” and “The Essential Buffett: Timeless Principles for the New Economy.” This is a great buy for value investors and belongs on every serious investors shelf at home.
Common Stocks and Uncommon Profits, originally published in 1958 and much like The Intelligent Investor, is a comprehensive investment resource. This book is a more compact guide on stock market investments. It contains topics including Fisher’s illustrious “scuttlebutt” strategy, what stocks to buy, when to buy and when to sell. The book also outlines how to apply Fisher’s ideas to suit your own needs.
Common Stocks and Uncommon Profits is by no means a simple guide to stock market investment. More advanced stock selection strategies are explored within this text. This book alone has provided me with the knowledge needed to begin investing in the stock market employing a growth stock approach, which will be explored further below.
Fisher’s investment philosophy was quite different to Graham’s. Fisher took what I call a growth stock approach. He purchased companies with a strong likelihood of increasing their earnings in the future. Consequentially, increasing their market quotation. Typically, “growth stocks” pay minimal if any dividend.
Fisher’s “scuttlebutt” strategy was based on the belief that every piece of information about a company should be exploited. This is to provide you with the highest level of knowledge about a stock before making a purchase.
Fisher would go to great lengths to learn more about a company before making an investment. He is known to have contacted current and former employees, suppliers and even top-level management of the company under consideration. To quote Fisher: “When it comes to selecting growth stocks, the rewards for proper action are so huge and the penalty for poor judgement is so great that is it hard to see why anyone would want to select a growth stock on the basis of superficial knowledge.” Now, a little bit about Fisher.
As featured on the back cover of the book, Phillip A. Fisher started his career as a securities analyst in 1928. He later founded Fisher & Company, an investment counseling business in 1931. He is known as one of the pioneers of modern investment theory. Fisher is reported to have made his clients extraordinary investment gains over his career and managed the company’s affairs until his retirement in 1999 at the age of 91.
Book #4: Unshakeable: Your Financial Freedom Playbook
Author: Tony Robbins
Unshakeable, published on February 28, 2017, is one of my favorite personal finance books. Not only is it a New York Times best seller, 100% of the profits from the book are donated by Tony Robbins to Feeding America.
The stock market is not the primary focus of this book, however there are certainly chapters directed towards stock market investment. Tony will teach you how to properly allocate your assets, explain why index funds are preferable over managed funds and teach you how to navigate through crashes and corrections in the market.
This is more than just a finance book. You will also learn how human behavior and psychology can negatively affect your investment returns, as well as how to combat those innate vulnerabilities that have been hardwired in all of us as humans. Seen on the back cover of Unshakeable: “No matter your salary, your stage of life or when you started, this book will provide the tools to help you achieve your financial goals more rapidly than you ever thought possible.”
Tony is an American author, entrepreneur, philanthropist and life coach. He is known for his infomercials, seminars and self-help books including Unlimited Power and MONEY: Master the Game. He is the founder of several companies that earn approximately $6 billion in annual sales. If you are looking for a book that encompasses more than just the field of investing, but the financial industry, this is a must buy.
Investing Simple is affiliated with Webull and M1 Finance. This relationship does not influence our opinion of this platform.
For the average retail investor, there has never been a better time to get started with investing in the stock market. Improvements in technology and algorithmic trading over the last 10 years have allowed new types of investment apps and brokerages to emerge. Many of these apps and brokerages are offered completely free to United States users.
In this article, we are going to outline 3 of the top free investment platforms and apps. Some of these picks are very well known and others still growing in popularity. Here is our review of the M1 Finance, Webull, and Robinhood investing apps. Each platform offers a different user experience, so it is important that you do your research before choosing which investing app to use.
1. M1 Finance App
M1 Finance is a new type of investing app that allows you to automate your investing 100% for free. You can invest in a variety of ETFs and stocks on the M1 Finance platform. Once you build your portfolio and deposit funds, you can sit back and allow your portfolio to be automatically rebalanced by the M1 Finance platform. Your entire stock market portfolio can be put on autopilot!
M1 Finance works by creating a portfolio called a pie. Within each pie you choose the specific stocks and ETFs that make up your pie. For example, you could have a pie that is 50% Facebook stock and 50% Netflix stock. You can have an unlimited number of pies on the M1 Finance platform as well as the option to put 100 holdings within one pie. For example, you could have a growth pie and an income pie on M1 Finance!
M1 Finance also offers expert pies created by securities professionals on their platform. M1 Finance is the only platform we have come across that offers this service on a completely free investing app. These prebuilt pies are designed for specific investment goals. You can invest for your retirement, follow specific industries and sectors, as well as follow your favorite hedge fund managers. M1 Finance offers these prebuilt pies completely 100% free. For those who do not want to build a portfolio from scratch, this can be a great option.
Pie investing through M1 Finance allows you to maintain a diversified portfolio even if you have a smaller investing account. One of the problems investors have faced for years is having a well diversified portfolio without having tens of thousands of dollars to invest. M1 Finance has created a solution by allowing you to invest in fractional shares for free!
For example, you can invest $100 into a pie that is 50% Alphabet stock and 50% Netflix stock. Traditionally, you would need over $1,000 dollars to build a portfolio consisting of only these 2 companies. M1 Finance has changed the game by offering fractional shares. This allows you to hold smaller portions of stocks within your portfolio and increase your overall diversification.
Automation is a big part of the M1 Finance platform. M1 Finance has a variety of features that allow you to passively manage your investments. Out of the 3 platforms we are comparing in this review, M1 Finance is the most automated. That is why, in most cases, M1 Finance is the best choice for passive investors.
M1 Finance Features
Dynamic Rebalancing: This is one of M1’s most useful features, giving you the ability to streamline your investments. When you deposit funds, M1 Finance will allocate those funds across the holdings in your portfolio. When you withdraw funds, M1 Finance will sell off proportional positions in your portfolio making sure you stay fully diversified. Dynamic rebalancing allows you to withdraw and deposit funds knowing that you will always be fully invested and you won’t need to actively buy or sell positions yourself.
Built In Tax Efficiency: M1 Finance allows you to minimize your tax liability by using tax efficient strategies when selling investments. M1 Finance is the only free investing platform we have come across that offers a tax efficient selling strategy for free.
When you withdraw money from your M1 Finance account, your investments are sold in this order:
Losses that offset capital gains
Securities or groups of securities that result in long term capital gains (lower tax rate)
Securities or groups of securities that result in short term capital gains (higher tax rate)
By using these tax minimization strategies, M1 Finance aims to keep more of your money invested. By doing so, they are saving you money in the long term and allowing for more compounding to build in your account over time.
Investing Schedules: Within the M1 Finance app, you have the ability to set up recurring deposits or withdrawals into and out of your account. M1 Finance will automatically invest or sell funds in order to satisfy your cash needs. When we said you could automate your entire portfolio with M1 Finance, we meant it!
Cash Balance Control: M1 Finance allows investors to set their preferred cash balance within their account at all times. If you were to need cash out of your account, you have it ready to go. You may also wish to hold a cash balance if you are dollar cost averaging into the market. Investing portions of your cash into the market over a period of time may be less risky during volatile market conditions. If you do not enable this feature, you will remain fully invested through M1 Finance.
The Verdict: M1 Finance
In most cases, M1 Finance is a great platform for passive investors. Most of their features cater to a long term passive investor who is sensitive to fees and taxes. M1 Finance has many strengths such as their smart rebalancing, tax minimization strategies and fractional shares. Another advantage is the ability to create your own portfolio of stocks and ETFs that fit your specific needs. If you are not comfortable with building your own portfolio, you can choose from M1’s expert pies that are built by their own securities professionals. M1 Finance would not be an ideal platform for active traders or people who make frequent trades in and out of the market. If you are looking for a platform for active traders, keep on reading!
Webull is an investing app you probably have not heard of before, but it made our list for a number of good reasons. Webull is a commission free stock and ETF trading app. Webull is designed for the active trader who is looking for a more dynamic, research oriented interface. Webull has a variety of features that benefit traders such as technical indicators, research agency ratings, financial calendars and free margin trading as well as short selling. With easy access to margin, research tools, and live data, Webull has built an ideal platform for active traders.
Webull is an app that is designed for the intermediate trader who already has some experience with the stock market. If you are a complete beginner, you might experience information overload. If you are a somewhat experienced trader, Webull will give you all of the data you will likely need.
Webull Free Stock Promotion!
If you sign up via our link, you will get a free stock worth up to $1,000! You don’t need to fund the account to get the stock, you just have to open it.
Technical Indicators: Webull has a variety of technical indicators available on the platform. You can choose from up to 22 technical indicators such as moving averages, relative strength indexes and more. Here is the full list in our complete Webull review.
Virtual Trading Simulator: Webull has a very useful feature called the virtual trading simulator. This feature lets you create a virtual portfolio with fake money to test out strategies before risking real money. This is an ideal feature for someone just starting out, who may need to gain more investing knowledge and know how before investing real money.
Smart Alerts: Webull lets you set a variety of alerts for different holdings. You can be alerted when a price level is hit, or a rate of change has hit a defined level. There are also alerts for volume levels or changes, this can be useful for traders get a sense of where the stock may be headed in the short term.
Financial Calendar: The financial calendar feature keeps you informed on all the latest and upcoming financial news. Important events such as upcoming IPOs, dividend payouts and earnings releases are all provided to you in a calendar format on the Webull app.
Margin Trading: Webull allows margin trading on its platform to certain users. You must have a minimum account balance of $2,000 to be approved for margin trading.
After Hours Trading: Webull offers after hours and premarket trading for free. You can trade securities from 4 am to 8 pm on the Webull platform offering more flexibility in placing trades.
Commission Free Short Selling: There are no trading commissions to short a stock in Webull. Short selling occurs in a margin account, but all trades are completely free.
The Verdict: Webull
Webull is a relatively new and growing trading platform, with new users discovering its unique functionality everyday. In most cases, Webull is an ideal platform for active traders looking to place trades 100% for free. With easy access to margin, research tools, and live data Webull has built a great platform for active traders.
If you sign up via our link, you will get a free stock worth up to $1,000! You don’t need to fund the account to get the stock, you just have to open it.
Robinhood is one of the most well known commission free trading platforms. It is easy to use and targets the beginner investor who is looking to save money by avoiding commission costs. Robinhood allows you to trade stocks, ETFs, cryptocurrencies and options commission free. The Robinhood user interface is simple and digestible and provides a good user experience for a complete beginner.
What you will find after using Robinhood for a while is that the platform becomes very limiting. While it is easy for a beginner to use, you will probably outgrow it in a few months. The lack of sophisticated charting and technical/fundamental metrics is a common complaint among Robinhood users. On the other hand, Robinhood was designed to be a beginner friendly platform.
Commission Free Trading: Robinhood allows users to trade stocks, ETFs, options and cryptocurrencies completely free. All investors benefit from saving money on fees. This is specifically useful for active traders who make frequent day to day trades.
Simple Interface: Robinhood is known for its user friendly interface. Its application is easy to use and not overwhelming like other platforms can be. This may be a benefit for certain investors who are just starting out and would like a simple and easy to use platform. For investors looking to conduct more research and build trading strategies, you may find the Robinhood platform is fairly limited.
Robinhood Gold: Robinhood offers a subscription service called Robinhood Gold. In the Robinhood Gold plan, you have the ability to trade pre and post market starting at 9 am and ending at 6 pm. Robinhood Gold lets you trade on margin once your account has a $2,000 minimum balance. Robinhood Gold costs $10 to $15 per month for this service.
The Verdict: Robinhood
Robinhood is one of the most well known free investing platforms. Being one of the first, Robinhood has spread in popularity faster than many of its competitors. That being said, we believe Robinhood may lack features that other free trading platforms offer. For example, margin trading and after hours trading is offered for free by Webull. You can only access these features on the Robinhood Gold subscription platform which costs $10-$15 per month. Short selling and research tools are additional features offered by Webull that Robinhood does not provide on their platform. Robinhood’s greatest strength is it’s ease of use and accessibility compared to other similar trading platforms. Robinhood also lacks many of the automation features offered by M1 Finance.
Everyone has a different preference for the ideal features offered on their investing platform. We believe the best platform completely depends on what type of investor you are. If you are an experienced active trader who likes to make frequent trades then Webull may be a better fit for your investment style. For those of us who are passive long term investors, who don’t make frequent trades, then I would check out the M1 Finance platform. Robinhood may be the best platform for beginner investors or traders who are looking for a relatively easy to use platform. Dividend investors would likely lean toward M1 Finance as this platform allows automated reinvestment of dividends. Each platform has its own unique features. In the end they are all free so you can try all three platforms to see which one you like best.
Before we go any further with this, we need to set some ground rules when it comes to discussing a stock market crash.
First of all, nobody knows when the next stock market crash will occur. While many will try to convince you otherwise, predicting the next crash is impossible. Warren Buffett explained this best when he said that market forecasters are out there to make fortune tellers look good.
Second of all, timing the market is impossible. A lot of people come up with this idea that they will be able to exit and reenter the market at the perfect time. While this idea looks good on paper, it probably won’t turn out like this. The reason behind this is because of what we already mentioned. You have no idea when the market has reached a top or a bottom.
Third and finally, no action is necessary on your part. If you want to take steps to prepare for a market crash, you can. However, this is not required. When it comes to investing, activity is often times the enemy. Emotions get involved when stocks are making drastic price moves, up or down and this often results in poor decision making. When it comes to the stock market, one of the best things you can do is often to do nothing at all.
What Is A Stock Market Crash?
The words crash, correction and bear market are often used interchangeably. It is important to understand the difference between these. While there is no official definition, here is what most people agree on.
A correction is a very frequent occurrence. This is a drop of around 10%. Stocks will correct all the time, and occasionally a broad market correction will take place as well. Recently, we saw this take place with the S&P 500. In 2017, the stock market virtually went up in a straight line. This trend continued into 2018 until a correction took place at the end of January. The S&P 500 corrected from close to $2,900 to $2,580 in February. This was a correction of 11%, which indicated that the market was blowing off steam after an unsustainable run.
A bear market is a less frequent occurrence. Over the last 100 years, we have seen a bear market on average every 3.5 years. A bear market is a drop of around 20%, and a full recovery typically takes place within 15 months. The last bear market we saw was from October 2007 to March of 2009, but this was actually what I and most would call a stock market crash.
A stock market crash is a very infrequent occurrence, happening about every 10 years. This is a massive correction taking place that far exceeds the 20% that marks a bear market. A crash is a drop of 40% or more. For example, the bear market of 2007 to 2009 resulted in a 54% drop in the Dow Jones Industrial Average. Before that, the last stock market crash took place in the early 2000s during the dot com bubble. A stock market crash is the result of unusual circumstances when a bubble has formed.
What Is A Bubble?
A bubble forms when herds of people begin to invest in a particular asset. As more people invest, the market value, or what people are willing to pay, drifts further and further away from the intrinsic value, or the actual underlying value of the asset. Eventually, the price gets so out of control that people are no longer wiling to pay it, and the buying pressure tapers off. As the price tapers off, people begin to sell and the price starts falling. This is far more common with individual assets, but entire markets can become a bubble. For example, the dot com bubble in the early 2000’s and the housing bubble a few years later.
The most recent example of this is the cryptocurrency bubble that formed in 2017. Bitcoin, the most popular cryptocurrency, went mainstream. In January of 2017, each Bitcoin was worth around $1,000. As the year continued, the price climbed higher and higher. At the end of this Bitcoin mania, each digital coin was trading for just over $19,000 in December of 2017. This massive run up indicated a speculative bubble had formed, as this level of appreciation is not common with any assets. People were excited over this new currency, but this excitement led to hysteria. The bubble burst at the end of 2017, and by February of 2018 each Bitcoin was worth just under $7,000. This was a drop of over 60%, which indicates that this was a crash. A market crash occurs as a result of unusual circumstances. In this case, it was millions of people herding into a digital currency.
From this point forward, we will be referring to both a crash and a bear market as a crash, but do remember the difference. As we have discussed, corrections and bear markets are regular occurrences resulting from normal circumstances. Crashes on the other hand, are irregular occurrences resulting from irregular circumstances or the formation of bubbles.
What To Do Before A Crash
If you believe that a market is becoming overvalued and you want to take some precautionary steps, here are a few that you could follow:
Simplify your portfolio. If you are holding individual stocks, consider what stocks you are investing in. Are you holding durable consumer staples stocks? Or volatile biotechnology stocks? If there is ever a time to invest in these high risk stocks, it is not when markets are at or nearing all time highs.
Increase your cash reserve. One of the best things you can do before a crash is to increase your cash on the sidelines. Stock market crashes result in one in a lifetime opportunities, and those with cash are able to jump on them. If you are fully invested in the market, you are completely immobilized in the event of a crash. Your only option is to ride it out.
Write down why you own what you own. You will want to have a clear idea of what you have in your portfolio and why you have it there. During a crash, emotions get involved and people will often make compulsive decisions. You should hold on to this written reminder in case you are tempted to take some kind of action.
Diversify. One of the best ways you can minimize risk is through adequate diversification. A good rule of thumb to follow is to never have more than 20% of your money in any one thing. If you do, you are probably too heavily invested in that asset.
Allocate more money into bonds or precious metals. During times of uncertainty, many investors will flee to other investments like bonds and precious metals. Gold has proven to be a suitable investment for outpacing inflation. On top of that, gold tends to hold up well in the event of a stock market crash as more money is being directed toward this asset.
Go for a walk. Seriously! It is easy to drive yourself crazy worrying about your money and your investment portfolio. You want to make sure that you are keeping your emotions under control as to not make an impulsive decision. You can take steps to prepare for a crash, but beyond that you cannot control it. If you cannot control it, there is no reason to worry about it!
What To Do During A Crash
If you believe you are currently invested in a market that is experiencing a crash, here are a few things you could consider doing:
Nothing. As mentioned already, one of the best things you can do during a market crash is to do nothing. Others around you will be generating a flurry of activity, and many will be making the fatal mistake of selling. Remember, it is not a loss until you recognize it! If you took steps to prepare for the crash and you are diversified across different assets, there is nothing for you to do.
Be patient. If you are planning on taking advantage of the sale and scooping up stocks, do not rush! During a bear market, there are often a number of false bottoms that will continue to be breached as the market falls. At this point, the market is a falling knife! Wait for clear signs of a bottom or follow some of the bear market investing strategies we will discuss shortly.
Write out a plan. Do not just randomly start buying stocks left and right. If you are planning on buying, consider what stocks you are looking to buy. Are you going to look for battered blue chips? Small cap stocks? You need to write out a clear action plan outlining what stocks you are looking to buy and at what price you are willing to pay. Failing to plan is planning to fail!
Educate yourself. This can be a perfect opportunity to educate yourself on the stock market and what is going on around you. Before you make any decision, do your due diligence. You might want to consider having a discussion with a financial expert before taking any action in a bear market.
Study the charts. While it is impossible to time the markets and identify the bottom, you can make an educated guess. By studying candlestick charts and learning about support and resistance areas, you can identify when a stock is testing a support. If it breaks down below the support, you know the stock is likely still in free fall.
What To Do After A Crash
If you believe the stock market has crashed and you are ready to take advantage of the opportunities, here are a few steps you could follow:
Dollar cost average. This is one of the best ways to enter the stock market, especially in a bear market. As we mentioned earlier, a number of false bottoms often appear during a bear market. If you drop all of your money in at one, and the bottom is yanked out from under you, you are in a free fall. By dollar cost averaging, you are accumulating shares over time and paying the market average for these shares. In a bear market, this is likely going to be averaging down or lowering your average cost basis. Let’s say you wanted to invest $10,000 in a S&P 500 index fund at the bottom of the market. Instead of dumping $10,000 in at once, you could invest $1,000 per month over 10 months to dollar cost average.
Blue chip and AAA rated. Another strategy you could follow is to only invest in durable companies with an excellent debt rating. Companies often raise capital by issuing debt obligations known as corporate bonds. These bonds are rated by agencies like Moody’s and Standard & Poor’s for credit worthiness. The highest rating a company can receive is a AAA rating. This company has a high degree of credit worthiness and the lowest risk of defaulting on these obligations. The problem is, increased corporate borrowing has significantly reduced the number of companies with this prestigious AAA rating. In fact, there are only two. First, Johnson & Johnson. Second, Microsoft. You might need to lower your standards to a AA+ or AA for a broader selection. Another option is to invest in what is referred to as blue chip stocks. These are durable companies that have stood the test of time. While there is no official list of blue chip stocks, most people refer to the Dow Jones Industrial Average.
Hunt for dividends. During a bear market, it is not uncommon to find a great company paying out a 10% dividend yield. It is important to understand that you should not simply look for stocks with high dividends! A dividend is never guaranteed, and a company could cut or cancel a dividend at any time. What you want to look at instead is the dividend growth streak. This is an indication of how long this company has been increasing the dividend payment. If a company has a 20+ year growth streak, they will do anything they can to continue paying that dividend. One of my favorite resources for researching dividends is Simply Safe Dividends. In this article, over 20 high dividend stocks are analyzed. For example, consider AT&T. This company has a dividend growth streak of over 30 years! It is possible that they could cut the dividend, but based on the growth streak and consistent operating history it is highly unlikely.
While you may be tempted to simply invest in the companies that have been hit the hardest, this might not be the best strategy. During each bear market, massive companies that were once considered institutions have gone bankrupt. This includes:
Lehman Brothers in 2008
Washington Mutual in 2008
General Motors in 2009
Pacific Gas & Electric 2001
These were massive companies that appeared to be safe, but this was not the case. If a company ends up going bankrupt, you are one of the last people to get paid as a shareholder. You will likely see nothing. Keep in mind, one of the best things you can do during a stock market crash is to do nothing at all. While you can take some precautionary steps to plan for a correction, you can never know for sure when it will take place.
Warren Buffett is arguably the most successful investor of our time. Buffett is still the chairman and CEO of Berkshire Hathaway at 88 years old. As of 2018, Warren Buffett has a net worth of $86.7 billion. Buffett is known for being a philanthropist and gives away a lot of his money. Over the last 10 years, this has amounted to more than $27 billion.
Despite being one of the richest people in the world, Buffett is known for being very frugal. He still lives in his Nebraska home that is worth around $650,000 today.
Aside from drinking more Coca Cola than most teenagers do, eating Cheetos and reading, Warren Buffett is a stock market investor. Warren Buffett earned most of his money from investing in companies and 99% of his net worth was earned after his 50th birthday.
Millions of stock market investors idolize Warren Buffett, and in this article we will be exploring 7 ways that you can think and invest like billionaire Warren Buffett.
1. Invest in what you know.
Did you hear about Warren Buffett buying weed stocks? Or getting in on the hottest new cryptocurrency to hit the market?
Warren Buffett is known for investing in simple businesses. He invests in what he understands. Cryptocurrencies and weed stocks would fall short of a lot of Buffett’s criteria, but the main point here is that he does not invest in something if he does not understand it. You shouldn’t either!
One of the easiest ways to test your understanding of a company is the elevator pitch. You have 30 seconds (the length of an elevator ride) to explain what that company is doing and why you are investing in it. If you can’t, you don’t understand what you are investing in. You need to be able to understand what the business does and what they are doing to make money. You should be able to identify the competitors, what isolates them from the competition and name their management team (more on that point later).
Warren Buffett does has some favorites. He invests heavily in banking, insurance, consumer staples and utilities. All of these businesses are easy to understand!
In the annual letter to shareholders, Berkshire Hathaway discloses the largest positions they have in companies. You can see a common theme here, with Apple being the only stock that sticks out. Despite shying away from technology and still using a flip phone, Buffett has a sizable position in Apple. Buffett invests in Apple stock because he believes they have extraordinary products that have become an essential part of our everyday lives. Beyond Apple, we see investments in financial services, banking, telecommunications, food and beverage, airlines, oil and automotive.
One of the other characteristics of companies that Warren Buffett invests in is durability. Buffett invests in durable time tested businesses. He invests in companies that have been around for decades with experience in all market conditions. If you want to invest like Warren Buffett, consider investing in some durable blue chip stocks. A great place to start is by looking at stocks on the Dow Jones!
2. Understand price versus value.
“Price is what you pay. Value is what you get.” – Warren Buffett
Warren Buffett is a long term value investor. He invests in companies based on the underlying value of the shares. Determining the underlying or intrinsic value of a stock is very difficult, which is why Buffett recommends that most people just invest in low fee index funds.
If you do want to learn about value investing, you should learn from the man who taught Warren Buffett. This was a man by the name of Benjamin Graham, mentor to Warren Buffett. In the book The Intelligent Investor, Benjamin Graham teaches the principles of value investing. Before you run out and buy a copy, be forewarned that this book is over 600 pages long and it was originally published in 1949! Despite the age of this book, the principles are still valuable and relevant.
Here is a book summary you might enjoy.
3. Invest for the long haul.
Warren Buffett is a long term investor. He patiently waits for investment opportunities, and once he buys shares he rarely sells them. Some of Buffett’s investments date back to the 1960’s! Warren Buffett started buying stock in American Express in 1964.
If you want to invest like Warren Buffett, you need to have a long term mindset when it comes to investing. Buffett does not care about what a company or stock is doing in the short term. He focuses on the long term and looks at what companies will have a long term competitive advantage over the next decade or more.
Stocks are a long term investment. The movement of the share price in the short term is unpredictable. Trying to bet on what will happen to a stock in the short term is near impossible. If you want to pick stocks, your best chance of success with that strategy is investing for the long term. Not to mention, you will have a significant tax savings as well holding stocks for the long term.
If an asset is held for one year or less, the capital gain recognized on that investment is considered to be a short term capital gain. This type of capital gain is taxed at the highest rate possible, typically the same rate as your ordinary income tax rate.
If an asset is held for over one year, the capital gain recognized on that investment is considered to be a long term capital gain. This type of capital gain is taxed at a lower tax rate.
4. Be greedy when others are fearful.
Benjamin Graham, mentor to Warren Buffett, once said that the market is a pendulum, forever swinging between optimism and pessimism. Warren Buffett learned a lot from Benjamin Graham. For example, Buffett has said that you should be greedy when others are fearful and fearful when others are greedy. Optimism leads to greed and pessimism leads to fear. Buying from the pessimist means that you are buying stocks when there is fear in the market, or buying low. Selling to optimists means that you are selling stocks when there is optimism or euphoria in the market, or selling high.
If you hear everyone talking about a hot stock, it is probably time to sell it. The underlying value of a stock does not change in the short term, only the price does. At some points, the price is high due to greed and feelings of euphoria. At other points, the price is low due to feelings of fear.
Most people make money in the stock market through asset appreciation. You buy shares at a low price and sell them down the road at a higher price. If you want to invest like Warren Buffett, do not buy shares of stocks at all time highs! You do not see Warren Buffett investing in the high flyers of the market because it violates (at least) two of his investing principles; price versus value and being greedy when others are fearful.
Stocks are the only thing people are afraid to buy on sale. If you go to the grocery store and find out Tide laundry detergent is 50% off, you would load up. If Procter & Gamble stock goes on sale, the producer of Tide, people are afraid to buy it! When a company stock goes on sale, you typically have a lot of talking heads on TV telling you to sell. This is actually the time when you would want to buy!
With the stock market, doing what is right often feels wrong.
If you study Warren Buffett, you will also find that he puts little stock in what Wall Street analysts have to say (pun intended).
“We have long felt that the only value of stock forecasters is to make fortune tellers look good.” – Warren Buffett
You will not find Warren Buffett glued to the TV on a Monday afternoon looking to catch up on the latest market opinions. Buffett is likely reading a book in his office. If you want to invest like Warren Buffett, you need to formulate your own opinion surrounding investments. While there is nothing wrong with having a discussion about stocks you own or are watching, you should not be swayed by the opinions of just anyone.
5. Buy Berkshire Hathaway stock.
One of the easiest ways to invest like Warren Buffett is to invest in his company Berkshire Hathaway. Berkshire Hathaway is a holding company owned by Warren Buffett. From 1965 to 2017, Berkshire Hathaway stock has had a compounded annual gain of 20.9% per year, compared to a 9.9% return from the S&P 500.
A lot of people are curious about the share price. The reason why Berkshire Hathaway stock trades at a share price of over $300,000 is that this stock has never been split. When the share price becomes out of reach for most retail investors, a company will often split the shares to make the price more accessible. Instead of splitting, Berkshire Hathaway instead offers Class B shares under the symbol BRK.B which currently trades at around $200 per share.
While Berkshire Hathaway has an impressive history of beating the S&P 500, you might not want to invest in this stock. The main reason is one that many large investment funds have as well. The larger a fund becomes, the larger the opportunities they need to find. It is difficult for a company with a market capitalization of over $500 billion and a cash pile of over $100 billion to find new investments.
Small and mid cap companies are essentially off the table. For Berkshire Hathaway to have a meaningful position in companies these size, they would likely have to own it. This limits investments and acquisitions to just the largest companies out there. For that reason, Buffett has said that it will be more difficult to generate market beating returns going forward.
Another important factor to remember is that Warren Buffett is 88 years old. If you are looking to invest for the long term, you will need a new strategy or leader once Buffett steps down or passes on.
“Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.” – Chinese Proverb
It is much more valuable to know how to invest on your own instead of simply following the strategy of someone else.
6. Pay attention to the management team.
Warren Buffett spends a lot of time learning about the management team of a company. A good management team is a characteristic of any company Buffett invests in. Buffett looks at how management treats shareholders, employees, customers and even the environment. Above all else, he looks for management to be honest with the shareholders.
Buffet looks at a number of factors including share buybacks, dividends, dividend growth and the overall company reputation. If management is acting responsibly, dividends should be paid on a regular basis with a long history of consistently raising that dividend. Shareholders should also be rewarded through a company sponsored share buyback program.
If you want to invest like Warren Buffett, get to know the management. Read the annual reports, earnings reports, watch interviews and study the career path of the company management team. Do they have an outside hire? Where did they work before?
7. Invest in the two fund portfolio.
If Warren Buffett hadn’t made a career of picking stocks, how would he have invested? Luckily for us, Buffett has answered that question. In a letter to shareholders, he outlined a retirement plan that anyone could implement with ease. It does not involve diligent research and stock picking. It involves investing in two funds.
The first is a low fee S&P 500 index fund.
The second is a short term government bond fund.
That’s it. Warren Buffett recommends investing 90% of your money in the S&P 500 fund and the remaining 10% in a government bond fund. As far as funds go, Warren Buffett recommends Vanguard products for good reason. They are known for having extremely low fees and wonderful financial products.
Instead of trying to beat the market, Buffett believes the average investor should own the entire market. It is important to remember that this portfolio is very broad and it is not specific to any persons individual needs. If you are looking for a long term investing plan, you should consider speaking with a financial advisor.
If you want to pick stocks and invest like Warren Buffett, follow these strategies! If you want to follow Warren Buffett’s investment advice, go for the two fund portfolio. At the end of the day, the most important thing is that you are investing!
Investing Simple is affiliated with Fundrise. This relationship does not influence our opinion of this platform.
Warren Buffett, arguably the most successful investor of our time, attributes his success to being born in America, some lucky genes and compound interest. Albert Einstein called compound interest the eighth wonder of the world.
For some, compound interest is the reason why they never have to worry about having enough money. For others, compound interest is the reason why they will never get out of debt. Those who understand it can apply this powerful force and accelerate their wealth.
One of the most amazing things about compound interest is that it does not discriminate. If you are rich, compound interest can make you richer. If you are poor, compound interest can make you poorer. It does not matter what race, gender, ethnicity or religion you are. Anyone in the world can earn compound interest, and it can change your life.
What Is Compound Interest
The easiest way to understand compound interest is to think of a snowy day. You go outside with the hopes of making a snowman and you begin packing a large ball of snow. Once you have a basketball sized ball of snow in your arms, you begin to roll it along the ground. At first, it appears that nothing is happening at all. It seems like you are rolling this ball of snow around for no reason!
This is the reason why most people give up, whether it be growing a business or growing your wealth. Most people are familiar with linear growth, assuming that the snowball will grow in size at the same rate every few feet that you roll it. The thing is, you are not experiencing linear growth, you are experiencing exponential growth. With this type of growth, the growth rate speeds up the larger something becomes.
Once that snowball is larger, it has a greater surface area to pick up more snow. It may have taken 2 minutes for the snowball the size of the basketball to double in size, but the next doubling cycle will take less time. This is known as the snowball effect.
The same effect can happen with your wealth as well. When you begin to earn compound interest, the returns seem insignificant at first. As you continue to allow your money to grow, the compounding effect becomes greater and greater and the growth rate accelerates. This is why many people refer to compound interest as the time value of money. It’s not about how much you have, it’s about how long you allow that money to grow.
When it comes to earning interest, you can either earn simple interest or compound interest. With simple interest, you earn the same rate of interest every single year. With compound interest, you are able to earn interest on your interest.
Consider the table below. This is the investment of $10,000 at 8% simple interest versus $10,000 at 8% compound interest over five years.
$10,000 @ 8% Simple
$10,000 @ 8% Compound
Compound interest allows you to earn a greater return every single year. While this change seems insignificant, the growth takes place over time. Using the snowball analogy, those initial years are the packing of the snowball. The growth is invisible to the naked eye.
Consider this. If you invested that same amount for 25 years instead of 5, the compounded return would amount to $68,484.75 compared to the simple return of just $30,000. In that 25th year of compounding, you earned $5,072.94 in interest!
“That’s great! But I don’t have $10,000 to invest.” – You
Here is one of the other great parts about compound interest. You can earn compound interest and experience this growth acceleration by investing a little bit each month over time. In this video, Ryan Scribner will show you how you can become a millionaire by simply investing $5 a day.
Rich people understand the power of compound interest, and they have likely been applying it for years. You might be wondering why so many rich people seem to have an endless supply of money. It is simply because they started investing their money and allowing that money to grow into more money over time. They understood the power of compound interest early on and they had the patience to see it through.
The number one skill you need to have in order to get rich is patience. Compound interest will not make you a millionaire over night. Earning compound interest is about as exciting as watching paint dry on a wall or grass grow in your lawn. Nobody became a millionaire overnight by investing in a low fee index fund. It takes time, patience and regular contribution!
On the other side of the coin, compound interest can be your enemy. Consider the credit card in your wallet. The debt on that credit card can compound in the same way that you can earn compound interest.
Let’s say you have a $5,000 limit on that credit card and you made the unfortunate mistake of maxing it out. Your interest rate on this card is a staggering 22% and you are making a payment of $100 a month.
First, how long will it take you to pay off this card?
And second, how much did you pay in total in interest and principal?
Don’t worry, if you are like most people you can’t answer this. It seems like something that would have been useful to learn in school, but I guess Hamlet was more important.
If you were paying off $5,000 in debt with no interest at $100 a month, it would take you just 50 months to pay off that debt. If you were paying off $5,000 in debt at $100 a month with 22% interest, it would take you 137 months to pay off that debt.
To answer the second question, you would pay $5,000 in principal and $8,678 in interest at a total of $13,678!
Would you rather roll a boulder uphill or downhill? Earning compound interest is like rolling a boulder downhill. Paying off compound debt is like rolling a boulder uphill. As we said before, compound interest does not discriminate. It can be your best friend or your worst enemy.
How To Earn Compound Interest
There are many ways that you can earn compound interest. Some of these methods are better than others, as you will see going through the examples. Interpreting compound interest rates can be confusing, so we are going to use the rule of 72 instead.
The rule of 72 is a great way to understand the power of the return you are getting. You simply take the number 72 and divide it by your average annual return. If you had a return of 5%, you would take 72 and divide it by 5 which comes out to be 14.4. What does that 14.4 mean exactly? It tells you that at a 5% compounded return, you would double your money every 14.4 years. The table below demonstrates the rule of 72 in action.
Years To Double
Moving on now, let’s discuss a few ways that you can earn compound interest.
1. Bank Account
While this is the worst way to earn compound interest, the interest earned from a bank account is compound interest. With a Savings Account, Checking Account, Money Market or Certificate of Deposit, you can earn compound interest.
The table below demonstrates why this is actually the worst way to earn compound interest. On top of that, you would not be able to outpace inflation earning interest rates this low and you would be losing the buying power of your money!
Years To Double
Certificate of Deposit
I don’t know about you, but I need to double my money more frequently than every 72 years or more. Let’s go ahead and discuss some other methods of earning compound interest.
With the stock market, higher risk yields a higher reward potential. Long term stock market investors can expect an average return of 10%. It is important to remember that you will not see this type of return every single year! This is the average return experienced over a long period of time.
At a 10% return, you would double your money every 7.2 years. This is why compound interest is referred to as the time value of money. A young person would be able to experience more of these doubling cycles than an older person. This is why it is imperative that you get started early. If you are a young person reading this, you have a huge advantage because time is on your side!
Another way you can earn compound interest is through dividends. Dividends are regular cash payments paid out to shareholders. A company can decide to retain earnings or share the earnings with shareholders in the form of dividend payments.
When you are investing in a dividend stock, you have two options. The first option is to receive these dividends in cash. The second option is to reinvest these dividends. Reinvesting your dividends allows you to earn more dividends from your dividends (the same thing as earning interest on interest).
Not all investing platforms are created equally!
Most of these investing accounts charge a fee to reinvest your dividends back into the issuing stock. If you are looking to earn compound interest through dividends, you should consider investing with M1 Finance. This platform allows you to reinvest your dividends for free!
Failing to reinvest your dividends can be detrimental to your wealth. If you are currently getting dividend checks in the mail, you should contact your broker and inquire about a dividend reinvestment plan. If your broker does not offer this, it might be time to shop around.
3. Real Estate
Another common way that people earn compound interest is by investing in real estate. Consider a flipper for example. This is a type of real estate investor who buys a piece of real estate, fixes it up and sells it for a profit.
In Year 1, they invest $100,000 in a piece of real estate. They fix it up and after expenses they make a profit of $15,000 on the flip. This investor made a return of 15%.
In Year 2, they invest $115,000 in another piece of real estate. They fix it up and they earn another 15% return, but this time it is a profit of $17,250!
At a 15% return per year, you would double your money every 4.8 years. Riskier investments have a higher potential return, and higher return investments will have a shorter doubling cycle.
One of the problems with investing in real estate is that it typically requires a high upfront capital investment. If you are looking to own a two family home, get ready to put down $10,000 or more!
Fundrise has come up with an interesting solution to this problem. Thanks to modern day technology, people from all over the world can pool their money together to invest in real estate projects. There are a number of advantages to this. First of all, the minimum to get started is just $500 making the barriers to entry significantly lower. Second of all, you are investing in a diversified pool of real estate and not just one property.
If you own a two family house and one of the units goes vacant, you just lost 50% of your rental income from the property. If you and 1,000 other people collectively own 10,000 units of real estate all over the world, one vacancy will not make a difference. That is the beauty of diversification.
Fundrise is a great investment option for earning compound interest!
Another way that people earn compound interest is through running a business. This is very similar to the real estate example above. For example, let’s say you had an Amazon FBA business and you were investing in inventory. Your initial investment could yield a 20% return or more, and the profits could be reinvested in more inventory yielding a greater return.
For most people, the best way to earn compound interest is through investing in the stock market. This is going to be the most passive method, as flipping real estate and running a business will be time consuming. It is important to remember that the most important factor when it comes to earning compound interest is time. While having a large amount of capital does help, it is not necessary. You can build a serious amount of wealth for yourself through small contributions on a consistent basis over time.
Most people believe they have a choice when it comes to whether or not they decide to invest. The truth is, you don’t. At some point, you need to start investing your money and saving for the future. You could be reading this as a 20 year old (lucky you) or someone who put this off until their 40s or 50s. Regardless of your age and financial situation, you need to be participating in some kind of investment to allow your money to grow into even more money.
“The best time to plant a tree was 20 years ago. The second best time is now.” – Chinese Proverb
Now, does this have to be a stock market investment? Absolutely not. Here at Investing Simple, we discuss all kinds of investments such as passive real estate investments, peer to peer lending and more. However, for the purpose of this article we are going to assume that you are interested in investing in the stock market.
At a time when consumer debt is at all time highs and stock market participation is at all time lows, I applaud you for reading this and considering entering the realm of investing. You might think the first step is to figure out what brokerage account to use and to start picking stocks. This is actually not the best way to do it. Some of you that are reading this might be ready to invest, but I am guessing most of you have a little personal finance clean-up work to do.
Phase 1: Pay Off Debt
Let me ask you a question. Let’s say you have $100 in the bank, but you also owe your friend $100. Your friend Bill is charging you $1.50 each month until that $100 is paid back. Now, your friend Jack calls you up and asks you if he can borrow $100. He agrees to pay you $0.50 a month until he is able to pay you back that $100.
A. Keep that $100 in the bank
B. Pay back your debts with Bill
C. Loan your money to Jack
If you picked Choice A, this is actually the worst move you could make. Your money is sitting in the bank earning a very small rate of return. For most people, this is a rate that does not outpace inflation. Your first goal when it comes to investing is to protect the buying power of your money by outpacing inflation. If you didn’t take economics class in high school, inflation is an increase in prices over a period of time. As prices increase, the buying power of each dollar decreases. To explain this simply, bread is more expensive now than it was back in 1930.
$100,000 Now = $98,000 1 Year From Now (2% Inflation)
Thanks to our friend inflation, your $100,000 will only buy you $98,000 worth of goods next year.
$100,000 Saved = $100,050 1 Year From Now (Is it really?)
Thanks to the “generous” interest rate paid by your bank, your $100,000 grew in value by $50! But since inflation was 2% and your return in your bank account was only 0.05% you really lost 1.95%
So what exactly happened here? You earned a return of $50, but you lost $2,000 worth of buying power. Your net loss was $1,950!
This is what people are talking about when they mention “outpacing inflation”. All investors look for investments that will either keep pace with or outpace inflation in order to maintain their purchasing power!
One of the best comparisons I have heard is that inflation is like having termites in your house. Day by day, it goes unnoticed. The real damage is done over a long period of time.
So what exactly happened here? You earned a return of $50, but you lost $2,000 worth of buying power. Your net loss was $1,950!
Keep this in mind when your friends or family members tell you they keep their money in the bank because it is safe. Termites!
If you picked Choice B, you chose the best option! It does not make any sense to loan your money to Jack when you owe Bill money. Now, you might argue that this could make sense if you could get a higher rate of return than you are paying in interest. This is something people try to do with the stock market. They borrow money against the shares they already own and they invest that borrowed money. This is known as buying on margin, a key contributor to the stock market crash in 1929.
On average, the stock market has averaged a return of 8 to 10% per year. This is the average, meaning you will not experience this every single year! In a bull market (a time when the price of stocks is rising), you could see returns of 15% per year or more. In a bear market (a time when the price of stocks is falling), you could see a 20% loss or more.
Buying on margin and investing borrowed money is a result of two things. First of all, it is a result of impatience. You are trying to accelerate your wealth and possibly make up for lost time. While I am not a financial advisor, I have yet to meet a single one that recommends that its clients invest borrowed money. Second of all, it is a result of not understanding compound interest. Einstein called this the 8th wonder of the world for a reason. Warren Buffett attributes a lot of his success to it. It is imperative that you understand the power.
In this video, Ryan Scribner explains how you could become a millionaire with just $5 a day thanks to compound interest.
I encourage you to play around with a compound interest calculator if you haven’t yet.
If you picked Choice C, you made a very common mistake. Most people are so excited about investing in the stock market that they do not consider their personal finances and whether or not it actually makes sense to invest at this point in time. As we mentioned above, the average return from the stock market is around 8 to 10% per year. Just to restate this, you will not experience this kind of return every year!
The most common debt people have is credit card debt. Since this is unsecured debt, it typically has the highest interest rate. It is not uncommon for people to have a 20% or higher interest rate on a credit card. If you have credit card debt, you need to pay it off before investing in the stock market. It is no different than loaning $100 to Jack when you owe Bill $100. The best return you can get at this point in time will be from paying off your high interest debt.
As a general rule of thumb, you want to pay off all debt that exceeds your anticipated rate of return from your investment. If that is 8%, you want to pay off all debt near, at or above 8% interest.
Now, what about a car loan or a mortgage? These are secured loans, so the interest rates are typically much lower. For example, if you are paying 4% interest, it would make sense to invest.
Let me give you an example. Let’s say you have a car loan of $20,000 but you also have $20,000 in the bank. You have good borrowing history, so your interest rate on this car loan is 4% per year. Rather than pay off your car loan, you decide to invest that money. Your anticipated rate of return is 8% over the next year.
Interest Paid = $800
Investment Return = $1,600
Net Gain = $800 or 4%
You were able to earn a return that exceeded what you paid in interest. On top of that, you were able to build your credit in the process.
In this video, Ryan Scribner talks about whether or not you should invest while being in debt. The same concepts are explained!
Summary: The point is, you do not need to be debt free to start investing. You just need to use common sense and pay off any high interest debt first. It does not make sense for most people to borrow money to invest. Buying on margin was a key contributor to the stock market crash of 1929, and I have yet to meet a financial advisor that recommends their clients invest borrowed money. Some debt is okay, as this will help you build your credit score. While the stock market historically returns 8 to 10% per year, this should not be expected every single year.
Phase 2: Eliminate The Need For Debt
Why do people go into debt? Sure, it could be compulsive spending or keeping up with the Joneses. However for a lot of people, debt is a result of an expense that was not anticipated or planned for. This could be something like a car repair or a medical bill. Once you have committed to being a participant in the stock market, you have hopefully followed the steps outlined in Phase 1. Unfortunately, the next step is not to go on a stock shopping spree. The next step is to eliminate the future need for debt.
Most people don’t plan on going into debt. You don’t wake up on a Saturday morning and say “I want a $3,000 credit card balance.” However, most people do not plan for unexpected expenses. Here is a tip: Don’t be like most people.
I am a big fan of Dave Ramsey. If you are still in the phase of paying off debt, I would highly recommend watching some of his videos.
The next step is to build up an emergency fund. This is going to eliminate the need for debt in the future. A general rule of thumb for this is that this should be enough to cover all of your expenses for the next 6 months. Pretend you lost your job or main source of income tomorrow. How long would you be able to sustain yourself before you needed to grab your credit card? If the answer is anything less than 6 months, you need to build up your cash cushion.
Let me give you an example. John has the following monthly expenses.
Car Payment = $300
Mortgage = $1,200
Utility Bill = $150
Food = $500
Entertainment = $200
Other = $200
Total = $2,550
John should have an emergency fund that covers all of his expenses for the next 6 months, or around $15,000. This money should be sitting in a liquid account like a checking account or a money market account. This money should not be invested. You might be saying that $15,000 is a lot of money. You are right! It would take most people at least one year to save up that amount of money. What you could do instead is invest half of your money and save the other half for your emergency fund. This would allow you to participate in the stock market while improving your financial situation.
“Wait a second, you just told us above that inflation is like termites and it is eating our money! Shouldn’t we invest our emergency fund?”
Here is another Dave Ramsey classic on the emergency fund.
Let me show you exactly why you should not do this. Let’s assume you buy shares of a red hot technology stock. You picked up 10 shares at a cost of $250 per share. In doing this, you drained your checking account and left yourself with $500 until payday. You picked up your shares the day before this company is reporting earnings because you anticipate that this stock will beat expectations. When this happens, the share price can go soaring!
The next day, they report earnings that fall short of expectations. The stock drops 15% on the news. Your initial investment of $2,500 (10 shares at $250) is now worth $2,125 (10 shares at $212.50). You “lost” $375. To tell you the truth, you didn’t lose a penny. You do not recognize a loss until you sell those shares to someone else at a price that is lower than what you paid for them. Often times, people will say that the stock market is a scam or that the stock market took money from them. As if the stock market reached into your brokerage account and plucked the money out! The stock market never took a penny from anyone. If you lost money, you handed it over.
Back on topic here, you are now down 15% on your shares of this red hot technology stock and you have $500 in checking. After listening in on the earnings call, you decide to go grab breakfast. You walk out to your car, turn the key and hear clicks. After punching the steering wheel a few times, you call a tow truck. Your car repair and tow bill ends up costing you $2,000! This was clearly an unexpected expense and like most people, you did not plan for it. Here is a tip: Don’t be like most people.
At this point, you have two lousy options.
Your first option is to sell your shares of the red hot technology stock and recognize the loss. You will use this money to pay for your car repair bill. On top of that, it will take 3 business days for the funds to settle before you can transfer the funds back to your bank account.
Your second option is to pull out that shiny credit card and slap on a $2,000 repair bill and tow at a 20% interest rate.
Both of these options are bad. If you end up in this situation, flip a coin.
Summary: Most people do not plan on going into debt. Usually, debt is a result of a lack of planning. An emergency fund will eliminate the future need for debt. A general rule of thumb is that you should have enough money in a liquid account like a checking account to cover all of your expenses for the next 6 months. You can contribute to your investing account as well as your emergency fund at the same time. Your emergency fund should not be invested.
Phase 3: Your First Investment
Have you ever seen a horse race before? Don’t worry, this will make sense shortly. People spend hours upon hours analyzing the horses and the different variables involved. Then, the horses go off and the fastest horse is the winner. No matter how much research is conducted by the handicapper, they are frequently wrong about what horse will come in first. Is this due to a lack of intelligence or research? In most cases, no. It is because horses are horses and sometimes they just don’t feel like running. But what if instead of picking the winner of this race, you were able to make a different bet on all of the horses? That’s right, you are betting on the outcome of the entire race and not just one horse.
This is exactly how stock picking works. Everyone has their own strategy when it comes down to the analysis of the investments, but at the end of the day nobody knows how the market will perform and what stocks will come in the lead. While you can’t bet on the entire horse race, you can bet on the entire stock market with an investment known as an index fund.
An index fund is a pool or collection of different stocks designed to replicate an underlying benchmark. This benchmark could be the S&P 500, foreign telecommunication companies or even the entire global stock market. This fund is designed to replicate the performance of the underlying benchmark as closely as possible.
It is important that you understand the difference between the index fund and the distant relative known as the mutual fund. A mutual fund is actively managed, and the expenses associated with this type of investment are often significantly higher. The truth is, most actively managed mutual funds do not beat the market. Mutual funds are often benchmarked against the S&P 500, an index that tracks the performance of the 500 largest publicly traded companies in the US. What most people do not realize is that you can simply invest in the S&P 500 through a low fee index fund instead of trying to pick stocks or pick a mutual fund that will hopefully outperform.
Most people should just buy low fee index funds. Now, am I telling you this to deter you from going out and picking stocks on your own? Absolutely not. It is possible to beat the market and you can learn a lot by investing in individual stocks. However, if you are brand new to investing you should start with an index fund. It is in your best interest to build your tolerance for risk and your understanding of the stock market before you begin to hold individual stocks. By holding ETFs, you get to experience what it is like to be a stock market investor without holding individual stocks that can be volatile.
In this video, Ryan Scribner talks more about index funds and ETFs.
Volatility is the degree of variation seen in the price of a stock. Individual stocks are far more volatile than the overall market, meaning you will see more drastic price fluctuations. One of the easiest ways to determine the volatility of a stock that you are looking at is to look at the beta. If a stock has a beta above 1, that means this stock is more volatile than the overall market. If the beta is below 1, that means this stock is less volatile than the overall market. If you are investing in individual stocks as a complete beginner, you should consider investing in stocks with a beta below 1.
Some stocks are inherently more volatile than others. For example, a technology stock like Advanced Micro Devices is going to see more variation in the share price than a blue chip stock like Coca Cola. These durable, time tested investments are named blue chip stocks after the blue chip in poker. The blue chip is the poker chip with the highest value. If you are looking to invest in an individual stock as a beginner, you should familiarize yourself with these blue chip stocks. A great place to start is the Dow Jones or DJIA. This is a list of 30 well established, financially responsible industry leaders. This includes companies like Apple, 3M and UnitedHealth.
If you want to participate in the stock market without picking individual stocks or building a portfolio from scratch, check out the platform Betterment. This is a roboadvisor that will build you a portfolio from scratch based on your age, time horizon, goals and risk tolerance. In most cases, betterment is a great option for beginners because they do not have any minimum account balance to get started. Betterment provides a completely passive approach to investing in the stock market. Betterment allows you to bet on the outcome of the entire race by investing in low fee index funds. Instead of building a diversified portfolio yourself, Betterment does it for you.
Summary: For most investors, especially beginners, your best option is to invest in low fee index funds. This will give you diversified exposure to the stock market. Warren Buffett recommends this too! If you do decide to invest in individual stocks, you should consider the beta or volatility of these investments. As a beginner, you should avoid stocks that have high volatility.
Phase 4: How To Make Money
When it comes to investing in the stock market, there are two different ways you can make money. The first way you can make money is through asset appreciation. You purchase a stock and hopefully sell it at a higher price in the future. It is important to remember that share prices can be completely erratic, and you should always invest in a company you fully understand. Consider the investing style of Warren Buffett. He invests in simple businesses like Kraft Heinz, American Express and Coca Cola. There is a lot of temptation out there to invest in complicated industries like biotechnology. At the end of the day, you need to ask yourself one question. Do I understand what I am buying?
The second way that you can make money in the stock market is through dividends. Companies can decide to share a portion of their earnings with shareholders through dividends. These dividends are typically paid on quarterly basis, but in some instances companies pay annual, semiannual or quarterly dividends. It is important to understand that these dividend payments are never guaranteed. A company that pays a dividend can cut or cancel this dividend payment at any time. Generally speaking, companies like to increase dividend payments over time and avoid a dividend cut at all costs. A dividend cut almost always results in a decline of the share price, which hurts the reputation of the company.
In this video, Ryan Scribner explains how money is made in the stock market.
Stocks that pay dividends are referred to as income stocks. Stocks that are growing at a faster rate than the overall market are referred to as growth stocks. You will also find that there are some stocks that are both growth and income investments. The company pays a dividend and it is also experiencing a faster rate of growth than the overall market.
You also have conservative growth stocks and aggressive growth stocks. As the name suggests, aggressive growth stocks are likely to experience a higher growth rate than conservative growth stocks.
When you begin investing in the stock market, it is important to consider what type of investor you want to be. Do you want to invest in aggressive growth stocks? Do you want to invest in durable blue chip stocks that pay dividends? Do you want to invest in stocks that pay dividends while also having growth potential? Like anything else out there, it is important to have a game plan and a strategy. A dividend investor would be focused on companies with a consistent operating history and a durable competitive advantage. A growth investor would be focused on what the most innovative companies are. Determining what type of investor you are is above and beyond the scope of this article, but you should begin to think about what type of investing seems most appealing to you.
Remember, if this seems too overwhelming you can always bet on the outcome of the entire race! This is why many investors simply invest in index funds rather than bother with picking individual stocks. If you are bullish on a particular sector or industry, like semiconductor technology, you can invest in a sector or industry specific ETF. You have no idea what the top performing semiconductor stocks will be, you just believe in that industry as a whole.
Summary: People make money in the stock market through asset appreciation or income from dividends. It is possible to invest in stocks that will offer both. Income investors buy shares of companies that pay dividends on a consistent basis. Growth investors buy shares of companies that are highly innovative and adaptive. It is important to understand what type of investor you want to be.
Phase 5: Core Investing Principles
There are a number of core investing principles that you should know before you begin investing in the stock market. You should also refresh your memory once in a while to ensure that you are following them. Here are the cardinal rules to sensible investing that will help you stay out of trouble.
Buy Low, Sell High
This is the most important investing principle, yet so few actually practice this. Let me give you an example. In 2017, Bitcoin went mainstream. Cryptocurrency was the topic of bar room conversations all over the world. By the time the average person learned about Bitcoin, it was trading at a price of over $10,000 per coin. Looking at the chart, you could see that Bitcoin had gone nowhere but up.
At this point, FOMO was triggered. Also known as the fear of missing out, masses of people entered the cryptocurrency market because they were afraid of missing out on the hottest investment. Do you know what all of these people did? They purchased Bitcoin at all time highs. To the untrained eye, Bitcoin had nowhere to go but up. Seasoned investors knew that the opposite was true. Whatever it is that you are buying, do not buy it at all time highs. People who are new to investing are often cautious about buying low. They see that the share price has fallen and they are afraid to buy. If you went to the grocery store and found out that Tide laundry detergent was on sale, you would stock up and buy extra. But when Procter & Gamble stock goes on sale, the maker of Tide laundry detergent, people are afraid to buy it. Stocks are the only thing that people do not buy on sale.
Ignore The Noise
When it comes to investing, noise is everywhere. There is always a line of people waiting to give you their opinion regardless of whether or not you wanted to hear it. To some extent, you can control the noise. Most of it is coming from the news outlets. Keep in mind that Wall Street makes money when you are active. Activity leads to trading and trading makes your broker money. Wall Street wants you to be active. They want you to invest in a stock on Monday and change your mind Thursday, sell it and buy something else only to sell that Friday. There is a difference between staying informed about your investments and being obsessed.
Check on your stocks once a day, maybe twice. Keep track of the major company announcements, quarterly earnings reports and annual reports. Beyond that, the rest is just noise. While investing in stocks can be a social activity, you should be careful about where you get your advice from. Hot stock tips are a dime a dozen. Beyond that, even if they are right about their hunch, what is your next move? Is your plan to wait for someone else to give you a stock tip at the bar? That is not an investment strategy. An investment strategy needs to be scale able and repeatable.
The Stock Market Is A Pendulum
A man by the name of Benjamin Graham once said that the market is a pendulum, forever swinging between optimism and pessimism. Warren Buffett learned a lot from Benjamin Graham. For example, Buffett has said that you should be greedy when others are fearful and fearful when others are greedy. Optimism leads to greed and pessimism leads to fear. Buying from the pessimist means that you are buying stocks when there is fear in the market, or buying low. Selling to optimists means that you are selling stocks when there is optimism or euphoria in the market, or selling high.
If you hear everyone talking about a hot stock, it is probably time to sell it. The underlying value of a stock does not change in the short term, only the price does. At some points, the price is high due to greed and feelings of euphoria. At other points, the price is low due to feelings of fear.
Don’t Put All Your Eggs In One Basket
If you are completely new to investing in the stock market and you want to place a bet on the stock of one company, I understand where you are coming from. As a beginner, you likely do not have a lot of capital to invest or you are just looking to get your feet wet with investing. It doesn’t make a lot of sense to try to diversify when you are investing a small sum of money. Diversification becomes more important as you invest more money.
For example, if you are simply looking to invest $1,000 diversification might not make a lot of sense at this point. Once you have invested $10,000 or more, you should consider diversifying. There are a couple of different rules of thumb you might want to follow. One of my favorite ones is never to have more than 20% of your money in any one thing. Some would argue that even investing 20% into one stock or asset is too risky. This all comes down to your individual risk tolerance.
What you are trying to avoid here is placing an all in bet. While it may be tempting to let it all ride on one particular stock, most would agree this is not a great strategy. If you are correct about this all in bet, the situation gets even worse as you fall under the hot hand fallacy. You will likely now believe that you have some skill above the ordinary investor and you will begin placing one all in bet after another and letting it all ride. At some point, your luck will run out. If you placed all in bets in the past and ended up ahead, consider yourself lucky and understand it is likely in your best interest to diversify.
Here is a great video by Fidelity that explains diversification.
Now, on the other hand, you do not want to make the mistake of being too diversified. Often times, a beginner investor mistakes diversification with buying dozens of different stocks. I can remember having a discussion with someone who had a portfolio of $5,000 and somehow was holding stock in 57 different companies. In most cases, he owned just one share. I asked him how he was able to keep up with all of those earnings reports and interviews. He told me he was not able to keep up with earnings and lost track of what he even owned. This is not diversification. This is stupidity.
My rule of thumb is to own 5 stocks at a time. Some people own more and some people own less. I find it is easy enough to keep track of all of the important information surrounding 5 companies. As an investor, you are a part owner of this company and you should be staying up to date on what is going on with the company. This means listening in on conference calls, reading quarterly earnings reports, keeping track of management changes and more. Being an informed investor takes time.
If you are looking to build a well diversified portfolio with a small amount of money, take a look at M1 Finance. This brokerage account allows you to invest in fractional shares of a company. In doing so, you can invest in as little as 1/10,000th of a share of a stock. This gives investors the ability to build a well diversified portfolio without investing $10,000 or more.
Valuing a stock is a complicated process. People have written entire books on strategies for determining the underlying value of a stock. This is a beginner’s guide, so I will not be going into great detail about this but it will be mentioned later. What I will tell you is that the share price has absolutely nothing to do with how cheap or expensive a stock is.
A lot of beginners make this fatal mistake when it comes to investing in the stock market. They see a stock like Amazon trading for close to $2,000 a share (as of October 2018) and they see these other companies trading for under $1. If they have $2,000 to invest, they can buy 1 share of Amazon or over 2,000 shares of this penny stock. What a bargain, right?
Wrong. In order to understand why this is not the case, we need to define a few important terms…
“Market Capitalization” – What the market has valued this company at.
“Shares Outstanding” – Total number of shares available.
Market Capitalization = Shares Outstanding X Share Price
Consider the following example. Company A issued 1,000 shares of their stock and the market has valued this company at $100,000. This gives each of these shares of Company A a value of $100. Company B on the other hand issued 100,000 shares of their stock and the market has valued this company at $100,000 as well. This gives each of these shares of Company A a value of $1.
Company A: $100,000 Market Cap = $100 X 1,000 Shares
Company B: $100,000 Market Cap = $1 X 100,000 Shares
The share price has nothing to do with whether or not a stock is cheap or expensive. It simply has to do with how many shares are available. Companies will often split the stock to lower the share price. Once a stock becomes out of reach for the average retail investor, the company will often split the stock in a given ratio. If you are holding a stock that splits, you will end up with more shares but the same ownership stake. Some companies, like Berkshire Hathaway, have never split their shares. Warren Buffett has stated he made this decision because he was looking to attract investors with similar goals as him. Eventually, Berkshire Hathaway decided to offer both BRK.A and BRK.B to provide retail investors with the option to invest. Most retail investors cannot afford to invest over $300,000 in one share of BRK.A!
Stocks Are A Long Term Investment
Not everyone will agree with me on this, but I share the same belief as Warren Buffett when I say that stocks are a long term investment. Warren Buffett believes that you should have a minimum time horizon of 5 years when investing in a stock. Investing with a time horizon of less than 5 years is speculation or gambling. You might be wondering about those who are trading stocks on a daily or weekly basis. I am a long term investor and that is my area of understanding. I do not know much of anything about short term trading. When I began investing, I tried my hands as a swing trader and I learned relatively quickly that this was not for me. Trading is completely different than investing, and it takes a unique type of person to be a consistently profitable trader.
I had the opportunity to interview a trader on the channel named Jason Graystone. Jason is a Forex trader and he has been doing this for over a decade. This interview is dense, at a length of over an hour, but the insight on what it takes to be a successful trader is immensely valuable. In the interview, Jason talked about something called the 90-90-90 rule. This is a well known fact that 90% of traders lose 90% or more of the value of their account in the first 90 days of trading.
The success rate with trading is extremely low. Successful traders have a very high risk tolerance and they have complete control over their emotions and do not involve them with trading.
Here is the full interview with Forex trader Jason Graystone.
Personally, I invest with a minimum time horizon of 1 year. The main reason why I do this is for tax reasons. In the United States, capital gains on investments can be classified as long term or short term capital gains. Believe it or not, there is a significant tax advantage associated with being a long term investor. If you buy a stock and sell it within 365 days, the gains are classified as short term capital gains and taxed as ordinary income. If you buy a stock and hold it for longer than one year before selling it, the gains are classified a long term capital gains. Depending on what tax bracket you are in, this could result in a tax savings of up to 20%.
In the short term, the price of a stock is unpredictable. The market can be volatile at times and stocks can move up and down for seemingly no reason. If you are unable to stomach these hills and valleys, you should not be an individual stock investor. You are better off investing in index funds as they are typically much less volatile. When you invest in a stock, have an idea in your head what the time horizon is that you plan on holding it.
If your stock goes up in the short term, you might be tempted to grab these easy profits. In some cases, it makes sense to do this. Keep in mind however that in doing so you are likely exposing yourself to short term capital gains! You will be paying the highest tax rate possible on your profits.
Timing The Market Is Impossible
You will always hear people talking about timing the market. The principle behind this is simple; buy when the market is low and sell when the market is high. This is unfortunately easier said than done. Most investors would agree that time in the market will always beat timing the market. If you get out of the market when it is high and it continues to climb higher, you miss out on potential gains. Whenever I am asked about this, I always tell people to look at some of the greatest investors like Warren Buffett. Do you see Warren Buffett jumping in and out of the market, moving from 100% stocks to 100% cash? Absolutely not. If Warren Buffett wouldn’t do it, you probably shouldn’t either.
I am going to keep this section short because I have written about this topic in depth in another article. You can read it here.
Speculate With No More Than 5% Of Your Portfolio
One of the greatest books you will ever read on the stock market is a book by a man named Benjamin Graham. That book is The Intelligent Investor. In this book, Graham discusses at length the difference between an investment and a speculation. Here is how he defines these two…
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” – Benjamin Graham
If you insist on speculating with your money, in the words of Benjamin Graham, you should do so with no more than 5% of your portfolio. Beyond that, you should speculate in a separate account as to not confuse this with investing. Graham also recommends that you do not continue to funnel money into this speculative portfolio. Instead, you should simply reinvest the earnings from your past speculations. If you are correct on your bet, you can reinvest that money into another speculation. If you are not correct on your bet, you should not funnel more money into a losing strategy.
It is imperative that you understand the difference between an investment and a speculation. Personally, I consider investing in any company that is not turning a profit as a speculation. As an investor, you are taking a gamble on whether or not that company will achieve profitability before going bust.
I have made speculations in the past, and I will likely make them in the future. One of my first investments was a total speculation, and it (kind of) paid off. I invested in Advanced Micro Devices (AMD) when it was $6.82 a share in August of 2016. At the time, this company had just gotten past the possibility of bankruptcy. They had not turned a profit in years and this was a total speculation. Not long after, the stock climbed to $7.51 a share in September and I sold. I made a profit of $0.69 per share on 1,000 shares, or $690. Immediately after that, the stock shot up to the $10 range by December 2016. Dang it! I got back in buying 700 shares and rode it to just under $15 in March of 2017, locking in a profit of around $3,500. At this point, I thought I was a genius and I decided I would swing trade these price movements. AMD stock retracted to $13.62 a share in April and I jumped on it. After that, AMD stock did not touch that price for over a year. That ended up being dead money in 2017. While the market soared, AMD showed no signs of life. In early 2018, AMD stock got caught up in a nasty sell off and fell into the $9 range in April 2018. At that point, I decided I was done with this stock and I would sell it at a breakeven at the earliest opportunity. After holding it for over a year and experiencing a dip of close to 35% I wanted out. I sold AMD for what I purchased it for and breathed a sigh of relief. Within 2 months, AMD was trading at $30 a share.
There are a few important lessons to be learned from this…
Had I held on to my 1,000 shares at a cost basis of $6.82 and sold at $30 a share (highly unlikely by the way), I would have had a return of 340%. My initial investment of just under $7,000 would be worth $30,000. This would have been a long term capital gain as well, resulting in significant tax savings.
By taking easy profits off the table, I earned a total of around $4,200. Still, this was not a bad return. These capital gains were short term capital gains, meaning I paid the highest tax rate possible on them.
A stock can go dormant for months or even years and suddenly come back to life.
Stocks like AMD are incredibly volatile, and drastic price fluctuations are to be expected.
In most cases, your best option when investing is to do nothing and stay the course.
Summary: Most people make money in the stock market by buying low and selling high. This typically means staying away from the market high flyers. While these stocks are getting the most attention from Wall Street, they are also the most likely to become overvalued. As an informed investor, you want to formulate your own opinion surrounding your investments. You do not want to buy whatever analysts recommend and sell whatever they don’t. Wall Street encourages buying high and selling low, a losing strategy. As a long term investor, you need to understand that the market is a pendulum and it is forever swinging between unjustified pessimism and unsustainable optimism. If you are looking to buy a stock that is soaring, you should be patient and wait for that pendulum to swing back towards unjustified pessimism. You want to avoid putting all of your eggs in one basket by placing an all in bet on one or a few stocks. You should also consider having some cash as well as other assets outside of the stock market. As an informed investor, you understand that the share price has no correlation to the valuation of a stock. Stocks are a long term investment, and in the short term the price movements can be totally illogical. While timing the market seems like a good idea on paper, it rarely works out in practice. Most long term investors would agree that time in the market beats timing the market. If you plan on speculating, you should limit it to a small portion of your portfolio. Speculating should not be confused with investing.
Phase 6: Why Stock Prices Change
As soon as you buy a stock, the price begins to change. If you watch the live charts, you will see that the quotation price for any stock is always changing. Why does this occur? There are a number of different reasons why a stock price changes. Some of these reasons are normal occurrences while others are red flags. It is important to understand the difference and what to look for! While the price of a stock is changing on a minute to minute basis, the underlying value does not change. Value investors look to acquire stock in a company when the price is below the underlying value. By understanding the difference between price and value, you can unearth opportunities where the market has priced something wrong.
As you can see above, the price of a stock is always changing. On this day, Apple stock opened at $219.79 and traded at a high of $223.36 and a low of $218.94. Every few seconds, the price at which people will buy and sell Apple stock changes. Do you think the value of Apple as a company changes every few seconds?
1. Earnings Reports
One of the most common catalysts for a price change is an earnings report. Publicly traded companies are required to report earnings to shareholders on a quarterly basis.On the days before and after earnings, you typically see more volatility. Wall Street analysts place bets on how they anticipate the company to perform that quarter. Typically, this is a bet on revenue and earnings per share. When you hear that a company beats earnings, it means that the actual figures came in above these Wall Street estimates. When you hear that a company misses earnings, it means the actual figures came in below these Wall Street estimates. Some companies offer guidance as well, which is forward looking earnings estimates. Changes to these guidance estimates can also result in drastic price changes in the share price. A company can raise or lower guidance based on their earnings data for the most recent quarter and anticipated sales.
Now, do not assume that beating earnings and raising guidance will result in an increase in the share price. Often times, the earnings beat is priced in and the positive news does not result in any price move. Betting on earnings is risky, and most investors would not recommend it. It is important to understand however that the share price typically has some drastic moves around earnings. As a long term investor, you should be more interested in the earnings report and earnings call. I encourage you to listen in on earnings reports as a well informed investor.
If earnings are positive and the share price moves, you should determine whether or not you feel the stock is fairly valued. Stocks can become overvalued very quickly as the herd moves in on a particular asset. If you believe the stock has become overvalued, you might want to consider selling off a portion or all. One of my favorite moves in this situation is to sell enough to cover my initial investment and let the profits ride. This is called playing on house money!
If earnings are negative, you could see the stock plummet. You should not sell simply based on the fact that the price went down. You should evaluate the fundamentals and see if there has been a drastic change. Here is a video I did talking about what to do when your stock crashes.
2. Dividend Changes
If you are an income investor or you are holding a stock that pays a dividend, you need to understand that changes to that dividend can result in movement of the share price. Remember, a dividend is never guaranteed! While companies like to continue paying and increasing quarterly dividends, it doesn’t always pan out this way. I experienced this with General Electric, one of my investments. I purchased the stock and a few months after I bought it, they announced a 50% dividend cut. Due to poor management of finances, General Electric was no longer able to pay this dividend. They were paying more in dividends than they were earning. After the cut was announced, the stock took a major dip.
A dividend cut will result in a price drop
A dividend increase will result in a price increase
A first dividend announcement will result in a price increase
Remember, this will not always be the case! The market is moody and erratic, and this leads to pricing that can be totally illogical at times. As a dividend investor, you want to keep track of the coverage ratio of your dividends. There are a number of different ways to calculate this, but this is the method I prefer:
Dividend Coverage Ratio = EPS / DPS
You want to take the earnings per share paid out over the last four quarters and divide it by the dividends per share paid out in the same timeframe. You will end up with a number that represents the dividend coverage ratio. If that number is below 1, it means that this company is paying out more in dividends than they are earning. This is a huge red flag as a dividend cut is almost guaranteed to occur. If the dividend coverage ratio is between 1 and 1.5, you should be careful. While a cut might not be immediate or necessary, this company has slim overage of the dividend. Ideally, I look for a coverage ratio of 1.5 to 2. This indicates that the company is retaining enough earnings to maintain financial health. On the other hand, if the dividend coverage ratio is well above 2 this can indicate that the company is retaining earnings and holding them back from investors.
For example, let’s calculate the coverage ratio of a popular dividend stock AT&T.
In 2017, AT&T paid out $1.97 in dividends on $4.76 earnings per share. The coverage ratio would be $4.76 divided by $1.97, or 2.4 indicating a heathy dividend. In fact, based on these earnings figures the dividend could even be raised. So far in 2018, AT&T has paid out $1 in dividends on $1.56 earnings per share. This is a coverage ratio of around 1.6, indicating a healthy dividend payout. You want to look at multiple years of data when using and calculating the dividend coverage ratio.
If your company is selling a product, understand that product announcements or recalls can result in a price change. Take GoPro for example. They planned on getting in on the drone market, but after months of development they pulled the plug on the operation. Investors were not happy and the price of the stock fell. A few years back, Chipotle had a recall of lettuce that had traces of e coli bacteria. While only a few dozen people got sick, this still has hurt them to this day. Physical product recalls typically have the same effect on a stock. Finally, new product announcements can result in a price move. Take Apple for example. Each year, they unveil the latest and greatest products. Wall Street essentially votes on whether or not they like the products with their money. If they love the new products, they buy. If they hate them, they sell.
As an informed investor, you should pay attention to any upcoming product announcements and anticipate price moves around these announcements. Apple has been releasing new products for decades and they have mostly pleased investors with their new ideas. Sometimes, a recall can result in a buying opportunity for investors. If you feel that the recall is not as severe as everyone is saying, this could be a good time to buy shares. In most instances, Wall Street overreacts to bad news.
Layoffs are not always a bad thing, but Wall Street typically thinks they are. If a company announces layoffs, you will often times see a sell off take place. Layoffs and consolidation efforts are not always a bad thing. A lot of businesses operate in a cyclical industry. This means that sales can be great at some points and poor at other times. If they are approaching the slow end of the business cycle, layoffs might be a very logical move.
On the other hand, layoffs often indicate consolidation and shrinking. It is similar to when stores close locations in an effort to save money. By closing stores, they have reduced their footprint and they have less retail locations to move product. This almost always results in fewer sales. If a company has massive layoffs, this could significantly reduce the innovation and research within the company. This almost always results in falling out of favor in the market.
Acquisitions almost always result in price moves. If you are holding a stock that gets acquired, you are typically having a good day. In most instances, the acquisition is seen as a positive. However, it is not always the case for the company that is acquiring the other company. Take AT&T for example. This year, they acquired Walt Disney. On the day that the deal was closed, the stock took a hit. The reason behind this was that investors were not happy with AT&T taking on more debt. As you can imagine, there are always different ways to interpret the news of an acquisition.
Public companies can also be taken private during acquisitions. Take Panera Bread for example. Back in April of 2017, a German company called JAB Holdings announced the acquisition of Panera Bread. They would be buying out the company and taking it private at $315 per share. If you were a shareholder at the time, you would have received $315 per share of Panera stock you owned. Companies typically pay a takeover premium when acquiring a company. This is expressed as a percentage above the current market value. When JAB Holdings purchased Panera, they paid a premium above the current share price. As a result, this is almost always good news for investors when a stock they own is taken private.
6. Stock Split
A stock split is typically something that is voted on, and it is becoming less and less common as years go on. Innovative brokerages like M1 Finance allow you to buy partial shares of a stock, making the need for stock splits virtually disappear. When the price for a single share of a stock climbs to a level that seems out of reach for the average retail investor, a company might decide to split the stock. Shareholders will receive more shares than they initially had in a ratio determined by the company. This is typically seen as good news, and new investors might decide to take a position in the company.
For example, on June 9th 2014 Apple completed a 7 to 1 stock split. Each outstanding share of Apple stock became 7.
Now, what we just mentioned above is a forward stock split. There is another type of split that is not desirable at all, and that is a reverse split. A reverse split occurs when a company needs to consolidate shares into fewer shares. Typically, this is done to fulfill listing requirements. Major stock exchanges like the NYSE and NASDAQ have a set of requirements a company must fulfill in order to remain listed on the exchange. If they do not meet these requirements, they can get delisted from the exchange. At that point, the stock would trade on a less desirable OTC exchange. A reverse stock split is seen as artificially inflating the price of the stock, and Wall Street is not a fan. This might be a confusing concept, so let me go through an example.
ABC Company has an initial public offering of 100,000 shares at $10 a share giving them a market capitalization of $1,000,000. In order to remain listed on a major exchange, they need to maintain a share price above $1. Everything possible goes wrong for ABC Company. They have a product recall, layoffs and earnings continue to miss. Two years after the IPO, the stock is trading at $0.55 a share. If they do not get the share price above $1, they will be delisted at the end of the year. Management has a discussion and they realize that the only option is to initiate a reverse split in a 5 to 1 ratio. The reverse split is voted on by shareholders and it passes. Now, each shareholder will receive 1 share per 5 they once had. Before the split, they have a market capitalization of $55,000 or 100,000 X $0.55 per share. After the split, the shares outstanding are reduced to 20,000 and the market capitalization does not change. As a result, each share is now worth $2.75 after the consolidation. Now, they can fulfill the listing requirements. The tricks do not fool Wall Street though, and the announcement of the reverse split results in a 5% sell off.
7. Management Changes
Management is like the captain of the ship that is a company. The management team determines what direction the company is heading in. Changes in management can result in price moves. Take General Electric for example. Recently, the new CEO was booted because the turnaround plans were not clear for this company. A new CEO was put in charge and Wall Street reacted positively to this change. On the other hand, if you suddenly hear about a member of management leaving the company this is usually a bad sign and Wall Street reacts accordingly.
As an informed investor, you should be familiar with the company management. A change of management is one of the only times where I will consider exiting a position. Good management can take a company to the moon. Bad management can bury them. If you find out that a company has changed management and you do not like the new leader, it might be time to evaluate whether or not you want to be a part owner of this company.
8. Scandals, Illegal Activity, Accounting Errors, Data Breach
I am lumping all three of these together as they almost always result in a share price move to the downside. Here are a few examples…
Often times, a broad market correction is taking place. This could be entire global markets or just a correction taking place within one industry. If you suspect this is occurring, you should simply benchmark your stock to a market index. If both the broad market and your stock are seeing a correction, this likely has nothing to do with your company. If the broad market is moving ahead and your stock is taking a dip, this is probably a price move that is isolated to your company and it is definitely a red flag. Further investigation is required!
The rest of these catalysts for a price change are economic factors. They have little to do with individual companies, but they almost always have an impact on the broad market. Often times, these are the catalysts behind a broad market correction.
10. Interest Rates
Changes in Federal interest rates always have an effect on the stock market. When the economy is in a slump, the Federal Reserve will often lower interest rates to artificially stimulate the economy. Lower interest rates are passed on to the consumer and corporations are able to borrow money at a cheaper rate. As a result, spending increases and the economy moves forward. On the other hand, when the economy is roaring and inflation is getting out of control, the Federal Reserve can hike interest rates to pump the brakes. This discourages corporate borrowing and lowers overall spending. Lower interest rates result in lower operating costs for companies, inflating earnings. Higher interest rates result in higher operating costs for companies, deflating earnings.
Interest rates also have an effect on the bond market, but that is above and beyond the scope of this article.
Unemployment is typically an indicator of how the overall economy is doing. In a prosperous economy, unemployment is low because companies are hiring left and right. In a poor economy, unemployment is high because companies are laying off employees left and right. Changes in the unemployment rate almost always have an effect on the overall market. Investors should pay attention to the unemployment rate and these jobs reports.
Politics can have a huge impact on the stock market. When Trump was elected, the market went into a sell off as this news shocked the nation. Each political officer has an agenda, and changes to government policy can have a positive or negative impact on the economy. For example, corporate tax cuts under the Trump administration have had a positive impact on the overall economy as corporate earnings have soared. On the other hand, as of writing this article we are amidst a trade war with China. These decisions on policies for how the US and China will conduct trade will have a massive impact on the overall market. This trade war has resulted in a bear market in China as of late 2018. An informed stock market investor should have a general idea of what is going on with the government and policies being enacted.
This article is a work in progress, bookmark and come back often!