October was a bumpy ride for equity investors. However, this return to more normalized volatility in the markets provides an ideal time to review some common sense principles to live by that will not only help your portfolio survive, but thrive through difficult periods.
Below are 12 common sense principles that I’ve adopted from one of our partners, Cardinal Capital Management. These principles are brilliantly simple and should be like gospel to those who wish to emulate the likes of Warren Buffett, the greatest value investor of all-time.
Rule #1 – Buy Quality
This sounds easy, but what is quality? Choose conservative, established companies with solid financial fundamentals. Meaning, not too much debt on the balance sheet and a strong history of dividends.
Rule #2 – Buy Value
A quality company only makes a quality investment if you pay the right price for it. Focus on quality companies that are trading well below their true worth (based on sound fundamentals).
Rule #3 – Be Patient
In order to buy quality companies at attractive prices, you have to be patient. Avoid the temptation to buy at expensive prices when the market is seemingly running away from you. Be patient. The market will reward the patient investor. Sometimes doing nothing, is not really doing nothing.
Rule #4 – Use Common Sense
You would think this would be the easiest rule to follow, but history proves otherwise. If you can’t understand how a company makes money, then you probably shouldn’t own it.
Rule #5 – Don’t Over-Diversify
You’ve probably heard the expression “Don’t put all your eggs in one basket”. However, there is a limit to the benefits of diversification. If you’ve selected good quality stocks, and you’ve waited patiently to buy them, then why would you want to diversify away all of benefits of that hard work? A diversified portfolio of 20-30 high quality businesses should outperform the market if you’ve observed rules #1-4.
Rule #6 – Hold Winners, Sell Losers
Avoid the temptation to sell your investments just because they’ve risen in value (as you expected they would). The time to sell your investments is when they no longer meet the test for “quality” or “value”. Likewise, avoid the temptation to hold onto an investment that has deteriorated in quality in hopes that you’ll eventually break-even.
Rule #7 – Emphasize Liquidity
Liquidity refers to how easily your investments can be converted to cash and not all stocks are created equal on this basis. Give preference to investments that are liquid. Flexibility in investing is worth something.
Rule #8 – Avoid Market Timing
Benjamin Graham, the father of value investing once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, in the short-term stock prices bounce around based on hype and hysteria, but over the long-term their prices move on substance. Don’t let the short-term market fluctuations influence your investment decisions.
Rule #9 – Reinvest Income
Albert Enstein has been credited with declaring compound interest as the eighth wonder of the world and “the most powerful invention in human history”. This principle applies to dividends reinvested to compound your wealth overtime.
Rule #10 – Build Wealth
This is the principle of paying yourself first. From every paycheck, save. Even small amounts applied with enough time and consistency will see your savings grow significantly.
Rule #11 – Stay Balanced
As effective as the stock market can be for compounding wealth over time, the reality is most investors should hold other assets in addition to stocks. This often includes holding real estate, bonds, cash and permanent life insurance to help to smooth out the ups and downs that are associated with investing in stocks. Equities should be for the long-term inflation-combating component of your portfolio.
Rule #12 – Don’t Over Trade
Many investors are constantly tempted to take action, rather than watching and waiting. While this may be a more exciting approach, the more buying and selling you do the higher your trading costs and the more tax that you’ll pay along the way. Sometimes the hardest thing to do is nothing.
Apply these common-sense, time-tested principles and you will be well on your way to achieving the level of long-term wealth and security that you desire.