Markets: Be an investor rather than a speculator
New York: September 09, 2003
By John R. Stephenson

Over the last three years we’ve witnessed some dramatic swings in the stock market. It wasn’t all that long ago that the tech heavy NASDAQ market stood at just over 5,000. Today it is less than half that amount. The pace at which the North American equity markets declined took even market professionals by surprise. Many of us are confused. Should we jump back into stocks now that the market has firmed up? What have we learned from the past few years that can prevent our portfolios from being whipsawed again? Where should we put our hard earned money? What are the rules that prudent investors should live by?

The first rule of stock market investing is to always invest with a long-term horizon in mind. The money that you invest in stocks should be money that you are investing for the long term. Think ten years. Want to make a quick buck by speculating on the direction of markets? Think again. There isn’t any consistent way to time the market and even professional investors are at a loss to get the timing right. Markets in the short-term (less than six months) are driven by emotion or sentiment rather than the fundamentals of the economy. Stock prices fluctuate, in the short-term, on the basis of recent news events and market/industry sentiment, making it extremely difficult to trade stocks profitably over short time horizons.

The biggest profits in the stock market are made when investors focus on value rather than on trends. By the time you recognize a trend (healthcare stocks might be a recent example) it is often too late. It is much better to scour the market for undervalued stocks that are in fundamentally strong industries and buy these securities before the market recognizes that they are cheap. The easiest way to determine the relative value of companies is by comparing the price earnings ratio (PE ratio) of an individual stock to the long term ratio of the market. If a stock is undervalued compared to the market as a whole (the long term PE ratio of the S&P500 is 15 times), then you have a potential winner.

Research and discipline pay off. If you buy what everyone else is buying you will get the same results as everyone else. In order to “beat the market” you need to think independently and buy stocks opportunistically in companies that you know and understand. If you’ve noticed the phenomenal growth of a retailer in your area, then that might be a stock that is worth investigating further. In a perfect world you want to be buying stock when everyone else is despondently selling and sell your stock when others are buying stock like crazy. This is extremely difficult to do as most of us would rather follow the herd then boldly strike out on our own path, but this contrarian attitude is important if you want to be a successful investor.

One of the most significant lessons of the past few years is to diversify your equity investments. Simply put: don’t put all your eggs in one basket. If you held a diversified portfolio through the recent downturn, then you would have faired much better than if you held mostly technology companies or worse yet a single stock. The employees of Enron who held only their company stock in their 401K’s learned a painful lesson about diversification. A good way to get some diversification in your portfolio is to consider both index funds and exchange-traded funds.

The only time to consider selling an asset is when you have found a better bargain. Change for change’s sake is a losing game. If you find a security that is trading at a bargain it is likely doing so because others are selling their shares in that company. Having a disciplined and independent view of the equity markets greatly enhances your ability to find winning investments in the equity markets.

The outlook for equities is the best it has been in many years with the market slowly retracing its steps. The next thirty or forty years should be extremely promising for the world’s equity markets and this might be an opportune time to start to invest again in the stock market, before the next great bull market.