Three simple rules for stockmarket success
Scott Phillips, of The Motley Fool, begins a new column for BusinessDay.
If you've taken even a passing interest in the stock market over the past few years, you'll know it's a market of ebbs and flows (for some, scary peaks and troughs). It would be easy to put shares in the "too hard" basket and walk away. Indeed, according to a recent survey, half of all American investors polled said they planned to do exactly that – forever.
Unfortunately, that's exactly the wrong choice, and those investors will pay the price if they stick to that conviction. The Australian stockmarket has returned a historical average of around 11 per cent since its inception. While recent history has provided examples of feast and famine, it's a brave investor who turns their back on a rate of return that promises to double your money (on a nominal, pre-tax basis) every seven years, through the miracle of compounding returns.
Volatility is all but assured, however investors who take a longer view – and ride out the waves – can profit by following a few simple rules.
Understand what you're investing in
It sounds like a simple platitude, but many investors forget that a share is nothing more or less than a fractional piece of a business. Whether it's Wesfarmers, BHP Billiton or CBA, each share represents a proportional ownership of the assets and liabilities of each business, as well as an entitlement to that fraction of future profits.
If you don't understand how a company makes money and what its risks and opportunities are, then you shouldn't own the shares – period. Warren Buffett calls it his "circle of competence" and it's the reason he famously avoided the dot.com crash at the turn of the century – he simply chose not to buy shares in companies he didn't understand.
If in doubt, hold fire
We're all human. We feel in control when we're taking action. The refrain of "do something… anything!" echoes in our brains, spurring us to act.
In an evolutionary sense, this impulse kept us safe from harm – it was better to be safe than sorry. In investing, however, there is always tomorrow. The ASX is open 250 days each year, and there's always tomorrow. Take your time, seek out more information, and gain a level of comfort in each potential investment before you pull the trigger. After all, your investment funds are too hard to come by to fritter them away on impulse.
Take a longer view
The average return of 11 per cent is exactly that – an average. And by definition, there must be years where the return is significantly below that number, and years that significantly exceed the mark. The point is that 135 years of Australian stockmarket history (including a Depression, two world wars, a couple of major nuclear accidents and many episodes of just plain greed and fear) has shown that riding out the peaks and troughs of the market have been incredibly profitable for the average investor who simply tracked the market returns.
Successful investing certainly requires judgment to identify superior business quality, and to ensure you pay a reasonable price.
The good news is those skills aren't as hard to learn as many would have you believe. Even if you never make the attempt, neither of those skills was required over the last century to simply earn the market's average return by following the index. There will be ups and downs, but the patience to ride out the bumps promises to be amply rewarded.
This article contains general investment advice only (under AFSL 400691).
Scott Phillips is The Motley Fool's feature columnist. The Motley Fool's purpose is to educate, amuse and enrich investors. BusinessDay readers can click here to request a new free Motley Fool report titled Two Safe Ways To Play The Commodities Boom.