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Most people know the stock market as a place where you buy and sell partial ownership of businesses, also known as “stocks”. Unfortunately, most people get the idea that the stock market’s price changes are random and that investing is no better than playing the lottery. While you KNOW some people can profit by investing in it, you might think that if YOU try you’ll end up losing… BADLY.
Well, if you understand how the stock market works and why it moves the way it does, then you can have realistic expectations and you’ll minimize the risks you’ll face when investing.
5 Tips for Understanding the Stock Market
1. Not Gambling
Unfortunately, a lot of people think that the stock market is like the casino. They think it’s all about “betting” on letters and numbers and that you’d almost always lose. Well, that’s true. You WILL almost always lose… IF you don’t know what you’re doing. If you think the stock market is like a game of roulette where you place bets randomly, then you will indeed lose.
Don’t forget that investing in stocks means you use your money to buy shares of ownership in companies. Be sure to buy GOOD and GREAT companies and don’t bet on “sure win” unknowns because your friend’s uncle’s nephew’s brother’s cousin said so. Now how will you know what companies are good? Simple. Study what makes companies good, when is the right time to buy them (i.e. they’re not overpriced), and then do your homework before you invest.
2. The Stock Market moves like a Drunkard
The stock market is VERY volatile. Its price changes is as unpredictable as a drunk man walking along a sidewalk. When you begin investing in a company’s stock (or an equity mutual fund) or set of stocks, you’ll notice that their price changes rapidly every day and every week. When you invest, sometimes the price increases and you win, and sometimes you lose, sometimes you win big, and sometimes you LOSE big right afterwards. Those price changes WILL test your nerves.
Will you get greedy when you see the price increase and hold on to the stock, hoping it increases further? Be careful when the price “corrects itself” (decreases) as you’ll hate yourself for it, OR when you sell immediately and hate yourself when the price DOES eventually increase further. There will also be times when the price decreases due to some bad news and you’re tempted to sell at a loss when, in reality, the business is still doing well. Very often, the price simply increases (and returns to normal). You must ALSO beware when there is legitimate bad news that the business is actually failing and you hang on to the stock hoping it goes back up when it won’t.
Again, do your homework. Study the businesses you’re investing in and make decisions rationally. You will make good decisions, and you WILL make MISTAKES. Don’t worry about it. It’s just part of life. Remember that if you DON’T invest, then you lose by default.
3. The Market Knocks Every Day
It’s said that one of Warren Buffet’s greatest contribution is the imaginary character called “Mr. Market.”
This Mr. Market is your business partner who is willing to sell you business shares (stocks), or buy shares you want to sell at prices that he sets. Mr. Market, however, is very moody. He sometimes offer prices that are too high, and sometime he offers prices that are too low.
If he thinks things are doing well, he’ll offer high prices when you want to buy or sell, like pricing an apple at $100 each because he thinks they’re worth that price (bad if you want to buy, good if you’re selling). On the other hand, if he thinks the world is doomed (or at least the market is), he’ll offer very LOW prices instead. Bad if you’re selling, but good if you’re buying. Now, your relationship with him never changes. You can choose to never talk to him or buy and sell stocks with him for years, but he’ll always be there knocking at your door every day with his ever-changing prices.
It’s all up to you whether you want to transact with him or not. If you know how to read him and how to value the shares he offers, you’ll certainly find a lot of good investment opportunities. If you can, follow Warren Buffett’s “secret” to investing: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” Will you buy stocks when they are far too expensive just because everyone else thinks things are going great (and suffer a loss when the price gets corrected)? Will you sell stocks you own at a loss when there’s a recession? …or will you sell when prices are too high and buy when stock shares of good businesses are at a discount?
*If you want to learn more about Mr. Market, go and check out The Essays of Warren Buffett.
4. Learn the Fundamentals
Benjamin Graham (Buffett’s teacher) said that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Although it sounds complicated, it’s not. It simply means that in the short term movements of days, weeks and months, the price changes according to people’s moods. In the long term, however, the stock’s price depends on the actual quality of the business.
When people feel confident about a business’ prospects, they vote with their wallets by buying it and the price increases. When they DON’T feel good about it (i.e. bad news), they vote with their wallets by avoiding it or selling their shares and the price decreases.
If you want to invest (as compared to trading and speculating, which is very similar to gambling), you have to remember that it’s the good and great businesses that become excellent investments that offer amazing returns. One way to go about it is to invest in established businesses, the other is to search for newer businesses that also have solid fundamentals (i.e. the “Amazons” and “Facebooks” when they first started).
Never forget this rule: Invest in excellent and sound businesses, NOT on fads and hype.
5. Past Performance will NOT guarantee Future Performance
Now that you’ve learned about the unpredictability of the market and the importance of selecting and investing in great businesses, this lesson probably wouldn’t surprise you: Past performance does NOT equal future performance. That “most amazing stock” of the past 3 years might become the WORST LOSER next month (and vice versa). None of us are able to accurately predict the future. All we CAN do is increase our chances.
Unless you’re really, REALLY good and you’re absolutely sure of it, try not to bet your life savings on a stock you’re so confident in. Like what Allen Saunders and John Lennon said, “life is what happens while you are busy making other plans.” You think this stock will make you a billionaire, but will life really go along with your plan? Who knows.
None of us can predict the future. All we can do is make educated guesses that can improve our chances of success.
I have one more lesson for you by the way. If you don’t try or practice, if you don’t invest for your future, then you will never become successful. Never forget THAT too!
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