One of the more cynical reasons investors give for avoiding the stock market is to liken it to a casino. “It’s just a big gaming,” some say. “The whole thing is rigged.” There may be just enough truth in those statements to convince a few people who haven’t taken the time to study it further.
As a result, they invest in bonds (which can be much riskier than they presume, with far little chance for outsize rewards) or they stay in cash. The results for their bottom lines are often disastrous. Here’s why they’re wrong:
1) Yes, there’s an element of gaming, but””
Imagine a casino where the long-term odds are rigged in your favor instead of against you. Imagine, too, that all the games are like black jack rather than slot machines, in that you can use what you know (you’re an experienced player) and the current circumstances (you’ve been watching the cards) to improve your odds. Now you have a more reasonable approximation of the stock market.
Many people will find that hard to believe. The stock market has gone virtually nowhere for 10 years, they complain. My Uncle Joe lost a fortune in the market, they point out. While the market occasionally dives and may even perform poorly for extended periods of time, the history of the markets tells a different story.
Over the long haul (and yes, it’s occasionally a very long haul), stocks are the only asset class that has consistently beaten inflation. The reason is obvious: over time, good companies grow and make money; they can pass those profits on to their shareholders in the form of dividends and provide additional gains from higher stock prices.
2) The individual investor is sometimes the victim of unfair practices, but he or she also has some surprising advantages.
No matter how many rules and regulations are passed, it will never be possible to entirely eliminate insider trading, dubious accounting, and other illegal practices that victimize the uninformed. Often, however, paying careful attention to financial statements will disclose hidden problems. Moreover, good companies don’t have to engage in fraud””they’re too busy making real profits.
Individual investors have a huge advantage over mutual fund managers and institutional investors, in that they can invest in small and even MicroCap companies the big kahunas couldn’t touch without violating SEC or corporate rules.
While these smaller companies are often riskier, they can also be the source of the biggest rewards.
3) It is the only game in town.
Outside of investing in commodities futures or trading currency, which are best left to the pros, the stock market is the only widely accessible way to grow your nest egg enough to beat inflation. Hardly anyone has gotten rich by investing in bonds, and no one does it by putting their money in the bank.
Knowing these three key issues, how can the individual investor avoid buying in at the wrong time or being victimized by deceptive practices?
Here are six actions you can start with:
1) Consider the P/E ratio of the market as a whole and of your stock in particular.
Most of the time, you can ignore the market and just focus on buying good companies at reasonable prices. But when stock prices get too far ahead of earnings, there’s usually a drop in store. Compare historical P/E ratios with current ratios to get some idea of what’s excessive, but keep in mind that the market will support higher P/E ratios when interest rates are low.
2) When inflation and interest rates are soaring, the market is often due for a drop”be alert.
High interest rates force companies that depend on borrowing to spend more of their cash to grow revenues. At the same time, money markets and bonds start paying out more attractive rates. If investors can earn 8% to 12% in a money market fund, they’re less likely to take the risk of investing in the market.
Of course, severe drops can happen in times of low interest rates as well. Look for red flags in the financial news, such as the beginning of the recent housing slump or the international credit crisis. Don’t let fear and uncertainty keep you from participating. Remember that the market goes up more than it goes down. Even poor market timers make money if they buy good companies.
3) Do your homework.
Study the balance sheet and annual report of the company that’s caught your interest. At the very least, know how much you’re paying for the company’s earnings, how much debt it has, and what its cash flow picture is like. Read the latest news stories on the company and make sure you are clear on why you expect the company’s earnings to grow.
If you don’t understand the story, don’t buy it. But, after you’ve bought the stock, continue to monitor the news carefully. Don’t panic over a little bit of negative news from time to time. Nearly every company has an occasional setback.
But if there is serious evidence of fraud or declining prospects, act quickly. Restating earnings is often a clear sign that all is not well with a company’s accounting practices.
4) Be patient.
Predicting the direction of the market or of an individual issue over the long term is considerably easier that predicting what it will do tomorrow, next week or next month. Day traders and very short term market traders seldom succeed for long. If your company is under priced and growing its earnings, the market will take notice eventually.
5) Take advantage of periodic panics to load up on shares you really like long term.
It isn’t easy to do, but following this advice will vastly improve your bottom line.
6) Remember that it’s not different this time.
Whenever the market starts doing crazy things, people will say that the situation is unprecedented. They will justify outrageous P/E’s by talking about a new paradigm. Or, they’ll bail out of stocks at the worst possible more