The Smart Investors 3 Step Guide

Smart Investors

As investors, we all want to beat the market, but most people have a hard time doing it, let alone doing it consistently. In this 3-Step guide, we explore some simple techniques that will give your portfolio the edge in 2012. Following these 3 simple rules, we will take control of your portfolio and position it to beat the market.

So what do smart investors do differently than the rest?

Investors who consistently outperform the market are actively engaged in the management of their portfolios. It is not enough to build a portfolio and walk away from it; rather, it requires constant review and fine tuning. The reason lies in the flow of new information.

The Basics

First, let’s understand some basics about the flow of information. The market is a pricing tool, which takes into account all available information every second of every business day. As new information is received, the market digests the information and makes a decision as to how much each company is worth, given the newfound knowledge. As the market goes through cycles, each time reassessing what companies are worth, prices adjust to the appropriate level. This constant fine-tuning by the market allows it to allocate more capital to the companies that will give investors the highest returns, and less to those companies that are expected to underperform. These instantaneous cycles that shift funds between companies, make the market both diversified and efficient, and enables it to get a healthy return.

Smart Investor

How can you beat that?

Sure, the market sounds intimidating – and it is – but there is one fact that gives investors a fighting chance. The market holds all invested money, which is more money than could possibly be allocated to just those companies that are doing well. Some of the money will inevitably remain with the companies which will underperform, and because of this, the gains will be offset by losses either partially or completely. If this wasn’t the case, it would be next to impossible to beat the market.

Investors who consistently outperform the market recognize the relationship between the flow of information and price, and constantly review their portfolios to make sure they are allocating capital to the stocks with the highest potential return on investment. Further, they are able to concentrate their investments into the securities that will outperform the market, whereas the market must allocate capital to all companies – the good ones and the bad ones.

To beat the market, investors need to be able to identify those stocks that will provide the best returns. However, any analysis is bound to be wrong for the simple fact that it is an estimate of things to come, and most of us are not in the business of predicting the future. Using this analysis, the investor will make a decision as to whether to invest in a company, and if so, how much. When an analysis is wrong, it may often be the difference between outperforming the market and falling short.

To beat the market, it is not enough for us to analyze companies. Incorporate these three simple rules into your investment strategy to give your portfolio an edge.

The Steps

Keeping a comfortable Margin of Safety is crucial to wise investing.

The First rule is to maintain a Margin of Safety. The concept is simple with an example: If the analysis estimates XYZ stock is worth $10 and you decide to maintain a 10% Margin of Safety, then you should invest in the XYZ stock at a price no higher than 90% (100% – Margin of Safety) of the price determined in the analysis. In the example I gave, this means 90% of $10, or $9. By applying a Margin of Safety to our analysis, we are allowing for error in the analysis. If an analysis has more uncertainty, a higher Margin of Safety should be used.

The Second rule is to Dollar Cost Average. This sounds complicated, but is not. In fact, if you have a 401k or an IRA, you are probably already applying the technique and didn’t know it. Dollar Cost Averaging is a concept based on a simple fact that successfully timing the market is almost impossible to do. One study showed that in order to produce successful returns, an investor would have to time the market right approximately 80% of the time. Dollar Cost Averaging allows us to invest our money at a fair price by contributing a fixed amount of money over time instead of trying to time the market. Learn more about Dollar Cost Averaging here.

The Third and final rule is to keep those commission costs low. The more times you make trades, the more fees you have to pay. For example, to invest $100, you may be required to pay a $7 commission on the trade. This fee is what a company will charge you to cover their costs and to execute the trade. For an investor to recover this cost, the stock would have to gain over 7%, and that’s just to break even. To breakeven and beat the market, this position might have to earn 15% or more! So, how can we lower our commissions? It’s simple, invest larger amounts, and invest less frequently. If you are scratching your head right now, don’t worry.  If you think that this rule is somewhat contradicting to our Dollar Cost Averaging rule above, you are correct. What we can take away from this observation is that it is important to strike a balance between the two rules where you are comfortable.

Investors who consistently outperform the market are not doing anything secret, they are simply investing their money in smart ways – they are “Intelligent Investors.” By applying these three simple rules to your investment strategy, you should be able to give your portfolio an edge.

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