The Five Rules for Successful Stock Investing
by Pat Dorsey
- Do your homework.
- Find economic moats.
- Have a margin of safety.
- Hold for the long haul.
- Know when to sell.
Investor’s Checklist based on Five Rules
- Successful investing depends on personal discipline, not on whether the crowd agrees or disagrees with you. That’s why it’s crucial to have a solid, well-grounded investment philosophy. Don’t buy a stock unless you understand the business inside and out. Taking the time to investigate a company before you buy the shares will help you avoid the biggest mistakes.
- Focus on companies with wide economic moats that can help them fend off competitors. If you can identify why a company keeps competitors at bay and consistently generates above-average profits, you’ve identified the source of its economic moat.
- Don’t buy a stock without a margin of safety. Sticking to a strict valuation discipline will help you avoid blowups and improve your investment performance.
- The costs of frequent trading can be a huge drag on performance over time. Treat your stock buys like major purchases, and hold on to them for the long term.
- Know when to sell. Don’t sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you can find better opportunities, or it takes up too much space in your portfolio. (Apparently I failed on this principle, for not wait until the stock has risen WELL above its intrinsic value.)
Know When to Sell
Ideally, we’d all hold our investments forever, but the reality is that few companies are worth holding for decades at a stretch—and few investors are savvy enough to buy only those companies. Knowing when it’s appropriate to bail out of a stock is at least as important as knowing when to buy one, yet we often sell our winners too early and hang on to our losers for too long. The key is to constantly monitor the companies you own, rather than the stocks you own. It’s far better to spend some time keeping up on the news surrounding your companies and the industries in which they function than it is to look at the stock price 20 times a day. Before I discuss when you should sell a stock, I ought to point out when you shouldn’t sell.
The Stock Has Dropped
By themselves, share-price movements convey no useful information, especially because prices can move in all sorts of directions in the short term for completely unfathomable reasons. The long-run performance of stocks is largely based on the expected future cash flows of the companies attached to them—it has very little to do with what the stock did over the past week or month.
Always keep in mind that it doesn’t matter what a stock has done since you bought it. There’s nothing you can do to change the past, and the market cares not one whit whether you’ve made or lost money on the stock. Other market participants—the folks setting the price of the stock—are looking to the future, and that’s exactly what you should do when you’re deciding whether to sell a stock.
The Stock Has Skyrocketed
Again, it matters little how those stocks have done in the past—what’s important is how you expect the company to do in the future. There’s not a priori reason for stocks that are up substantially to drop, just as there’s no reason for stocks that have tanked to “have to come back eventually.” Most of us would be better investors if we could just block out all those graphs of past stock performance because they convey no useful information about the future.
When should you sell? Run through these 5 questions whenever you think about selling a stock, and you’ll be in good shape. eg: AAPL
1. Did You Make a Mistake? No
Did you miss something when you first evaluated the company? Perhaps you thought management would be able to pull off a turnaround, but the task turned out to be bigger than you (and they) thought. Or maybe you underestimated the strength of a company’s competition or overestimated its ability to find new growth opportunities. No matter what the flub, it’s rarely worth holding on to a stock that you bought for a reason that’s no longer valid. If your initial analysis was wrong, cut your losses, take the tax break, and move on.
2. Have the Fundamentals Deteriorated? No
After several years of success, that raging growth company you bought has started to slow down. Cash is piling up as the company has a tougher time finding profitable, new investment opportunities, and competition is eating away at the company’s margins. Sounds like it’s time to reassess the company’s future prospects. If they’re substantially worse than they used to be, it’s time to sell.
3. Has the Stock Risen Too Far above Its Intrinsic Value? No
Let’s face it: The market sometimes wakes up in an awfully good mood and offers to pay you a price far in excess of what your investment is really worth. There’s no reason not to take advantage of other investors’ good nature. Ask yourself how much more the market is willing to pay you than your estimate of the value of the stock and how likely it is that your estimate of its value could go up over time. You don’t want to sell wonderful companies just because they get a little pricey—you’d incur capital gains and wouldn’t be taking advantage of compounding. But even the greatest companies should be sold when their shares sell at egregious values.
4. Is There Something Better You Can Do with the Money? No
As an investor, you should always be seeking to allocate your money to the assets that are likely to generate the highest return relative to their risk. There’s no shame in selling a somewhat undervalued investment—even one on which you’ve lost money—to free up funds to buy a stock with better prospects. I did this myself in early 2003 when I noticed that Home Depot was looking awfully cheap. The stock had been sliding for almost three years, and I thought it was worth about 50% more than the market price at the time. I didn’t have much cash in my account, so I had to sell something if I wanted to buy Home Depot. After reviewing the stocks I owned, I sold some shares of Citigroup, even though they were trading for about 15% less than what I paid for them. Why? Because my initial assessment of Citigroup’s value had been too optimistic, and I didn’t think the shares were much of a bargain any more. So, I sold a fairly valued stock to purchase one that I thought was very undervalued. What about my small loss on the Citi stock? That was water under the bridge and couldn’t be changed. What mattered was that I had the opportunity to move funds from an investment with a very modest expected return to one with a fairly high expected return—and that was a solid reason to sell.
5. Do You Have Too Much Money in One Stock? No
Let’s face it: The market sometimes wakes up in an awfully good mood and offers to pay you a price far in excess of what your investment is really worth.
Conclusion: I should NOT sell AAPL.
Seven Mistakes to Avoid
- Swinging for the fences.
- Believing that it’s different this time.
- Falling in love with products.
- Panicking when the market is down.
- Trying to time the market. failed
- Ignoring valuation. failed
- Relying on earnings for the whole story.
- Trying to time the market.
- Ignoring valuation: The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for—not because you think a greater fool will pay more for the shares a few months down the road.
Why I bought and sold AAPL:
- Goal for buying AAPL: Get 20% ROI
- Selling: I sold out AAPL at $203 in August because of the staggering price around $200 for weeks and the looming global recession. My fair value estimation of AAPL back then was around $200 to $210, now the fair value has grown to $220 and the market price has come to an all time high $255. Had I known ……, I would have hold it longer without losing the opportunity to earn $11,000 (200x$55). So again:
Q1: How do I know if the price will keep going up or not? Is it even knowable?
A1: No, it’s NOT knowable.
Q2: What would you do to correct this mistake?
A2: Two things:
- I should give myself a solid reason of selling AAPL: that is if the intrinsic value (moat, management, ) of Apple Inc. “decreased“.
- I should sell “partially” NOT “ALL” at once.