The goal is to make good returns over the long-term.

Making Money In The Stock Market - Demystified
posted December 9, 2008 - 1:36am

The key to making money in the stock market is to earn a high-level finance degree, or listen to those on TV who already have one… right?

Of course not. You don’t need a financial degree to make good money in the stock market. Neither do you need to listen to the so called “gurus” on TV, in fact you would be better off ignoring what the gurus are saying. All you need to make money in the stock market is a little knowledge, and a check on your emotions. The toughest enemy that investors face is their own emotions. Let me throw out an example:

John Q. Investor watches a stock market expert on TV and hears, “Sales of XYZ software company has tripled over the last six months and the stock price has skyrocketed to its 52-week high. The company is expected to increase revenue another 25% in the next year. There looks to be a lot more upside for this company.” This news sounds great! So a very excited John Q. Investor calls up his stock broker, or logs into his online brokerage account the next day, and buys 100 shares of XYZ company at $50.00 per share. Confident that making a lot of money on this stock is a sure thing (after all, a financial guru is pushing it) John Q. prepares to watch the stock price soar. Maybe this is the stock that will enable an early retirement! Two weeks later, some bad news is revealed. A fortune 100 company installed the latest version of XYZ’s software, only to discover a security glitch that exposed top secret product design drawings on their website. Immediately, XYZ’s stock price plummets to $30.00 per share. John Q. is very concerned when he sees his $5,000 investment drop to $3,000 over night. The next day doesn’t help the stock at all and it drops another $10 per share. John Q. Investor is strapped with fear as he sees that his $5,000 investment is now only worth $2,000 and still dropping quickly. He panics, and by the time he can sell all 100 shares it has dropped to $15 per share. So his “sure thing” $5,000 investment lost him $3,500 in two weeks. John Q. is determined that he has no business investing in the stock market and pledges to never invest in the market again.

The scenario above is quite common… especially with the recent problems in the economy. People have just gotten hammered by this current market! But here is the problem with the above scenario. What prompted John Q. Investor to purchase stock in XYZ company? He heard a supposed expert saying that the stock was soaring higher and higher… a sure thing, and he got “greedy” and bought the stock. Greed is an emotion that needs to be kept in check. Something that is overlooked by many people trying to make money in the stock market, is that making money is only half of the equation. The other half of the equation is the possible down-side risk of a stock. This stock was up at its 52-week high… its most expensive price. If you look at buying stocks the same way you would look at buying a car, or a washing machine you would make wiser decisions in your stock picking. Let me explain what I mean. If you are in the market for a new washing machine, do you go buy it at the most expensive price that you can find? Of course not. You may call or visit different stores, or go online looking for the “best price” that you can find for that particular washing machine. Stocks should be bought the same way. You buy them, ideally, at the lowest possible price. This reduces the “down-side” part of that equation. You don’t buy a stock at, or even near, its 52-week high… the down-side risk is too high. When you buy stocks, you look for companies that are financially strong; with history of good growth, good revenue, little to no debt, nice profit margins, and a low profit/earnings ratio for its industry. The lower the profit/earnings ratio (Profits divided by Earnings), the least expensive that stock is. If you are comparing two consumer goods companies with comparable revenue and debt, but company A has a P/E of 16 and company B has a P/E of 11. Company B has less down-side potential (less risk) than company A. Company B is less expensive than company A… even if company B’s stock price is higher than company A’s.

So when you are looking to invest your hard-earned money into the stock market, don’t be frightened away by recent price fluctuations or even by the current economy. Study the financials of strong businesses; compare companies within the same industries and choose the ones with the strongest financials, and the least amount of down-side potential and put your money on those companies… then don’t worry about short-term price fluctuations. The goal is to make good returns over the long-term. This investing style is what is known as “value investing”, and it has been proven the most successful style of investing since its inception in the 1930’s.

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