Making money on the stock market is not as simple as buying a few company shares, waiting for a few days, selling, and making money. In all honesty, I wish it were this easy. I wish everything I bought went up in value, and wish I never lost money. Sadly, I have and will continue to lose money, but by following a few special investing rules, I can hopefully, limit those losses.
Below are ten rules that I follow when I’m investing in the stock market, and think you should as well.
Rule Number One: Stay Away from Penny Stocks
Penny stocks are typically companies that trade for less than £1 in the UK or have a market cap of less than £100Million. Investment Advisors generally regard penny stocks as a purely speculative investment because they are usually, small, low-valued business that make little or no profit and often don’t have a fully developed product. They also don’t pay dividends as all revenues are reinvested back in the company for growth. Most penny stocks are confined to the AIM, or they will be traded on the OTC (Over-the-Counter) markets.
Most investors see Penny Stocks and think they can multiply their money by 100’s of per cent quickly, with little risk. If you get it right, this might be the case. Take the online retailer ASOS. If you had invested £1,000 back in 2001, they would be worth over £300,000 today. The problem is that for every company that makes money, hundreds don’t or go bankrupt, leaving angry investors with a significant loss.
Rule Number Two: Stay Away From Options, Leveraged ETF’s and CFD’s
In the first few years of trading, you need to stay away from Options, Leveraged ETF’s and CFD’s. All these instruments are great for increasing short-term returns, but they also add another layer of risk, that can seriously lose you money.
- Options work by allowing you to pay a premium for the “Option” to buy or sell a stock. In principle, this sounds great, but reality, often the option expires worthless, and you suddenly find those premiums quickly add up.
- CFD’S allow you to put down 10% of the cost of the trade and effectively borrow the rest. They are great for very short-term trades but see rule number four. Secondly, the carry-over charges overnight are expensive and most importantly, according to statistic, 98% of traders lose money
- Leveraged ETF’s are as the name suggests ETF’s that are leverage. It’s possible to trade either 2x or 3x ETF’s, but you should be avoiding both. The problem with leveraged ETF’s is how they are built. Again, they’re great for short-term trades but see rules number three.
Rule Number Three: Don’t Borrow Money To Buy Stocks
Debt is very cheap today. In fact, I could easily borrow another £100K in mortgage from my property to invest in the stock market, but I won’t because it’s not a good idea. The biggest problem with borrowing to invest is the time scale.
I’m confident that if you buy a FTSE-100 ETF Index today and hold it for ten years, you will make money. History shows that you have a 90% chance of making money over this period, but can you hold the debt? What happens if we have another financial crisis and markets fall by 30%, and can no longer afford to maintain the debt? You’ll have to sell your shares at a rock bottom price to cover the debt.
Rule Number Four: Focus on Long-Term Gains
If you want to make money off the stock market as a retail investor, you need to invest for the long-term. I’m not a professional investor, I don’t have a crystal ball, and while I like to think I can buy low and sell high, I’m not very good at predicting the market. That said, my trading account has averaged over 10% a year for the majority of the last ten years.
If you bought the FTSE100 Index ETF and hold for a week, you have a 36% chance of making money. Hold the stock for a month and this rise to 50%, and to 65% if you hold for a year. If you hold it for more than ten years, you have a 90% chance of making money.
Rule Number Five: Never Sell
Selling is the hardest part of making money on the stock market. Actually, it’s very easy, it’s just a click on a button on your trading platform, but here’s the problem. Once you sell, then what are you going to do? Over the years, I’ve had so many stocks that have lost 10% of their value one day, only to bounce back over the coming days and weeks.
If I had sold my stock, firstly I would have to have accepted a significant loss, but secondly, I would have no idea what would I do with the money. If the stock market kept rising, I would spend the time beating myself up because I sold to early. If stocks sold off, I would think I was a genius, but would now have a hard time knowing when to get back in.
Would I try to time the market bottom? Defiantly not, because the whole time I would be worried whether stocks would drop further. If they rebounded 10%, I would have assumed it was a dead-cat bounce and stocks would go even lower soon. How about after a 30% rally? Nope, I would believe I had missed the rally, and an even bigger pullback is coming given nothing has changed in the stock or the economy.
Would I ever get back in? I’m not sure, and for this reason, I never sell.
Rule Number Six – Build A Diverse Portfolio
You need to make sure you hold at least twenty different stocks at any one time. Not every stock is going to be a winner, and some stocks you buy will lose money – It is a fact. But, by buying a portfolio of twenty different stocks, you will have the best chance of finding those major winners, while reducing the effect those losing buys have on your portfolio.
One point, watch out for dealing charges, especially early on in your investing time horizon. Yes, you should be building a diverse portfolio, but this can be built over time.
Rule Seven: Watch Out For Fees
In the early day’s of your investing time horizon, I would suggest that you set yourself up a Share ISA with Hargreaves Lansdown who are a leading savings and investment platform based in the UK. It free to set up and has no dealing charges to invest in funds. This would allow you to invest a small amount of money each month cost-effectively.
That said, you still need to focus on fees. As an example, Funds A and B have annual fees of 0.7% and 1.7% respectively. If you invested £5,000 a year for 20 years and they grew by 10% each year, you’d have £289,000 in fund A but only £256,000 in fund B. That extra 1% you have been paying in fees, would cost you £33,000.
Fees also apply to buying and selling shares. My dad recently told me how he purchased £400 of BP. It was only after a discussion that we realised this was a terrible trade. £400 bought my father about 150 shares give they are trading at £2.60 per share. The problem is that it cost him £10 to buy, and another £10 to sell. The £20 cost to buy and sell, means that he needs to generate 5% returns, to cover the cost of the trade.
Rule Eight: Focus on Pound Cost Averaging
Stocks will fall 10% to 40%, then bounce back over the course of your investing time horizon. It’s a fact and not one that can do much about. If you’re anything like me, you’re not going to be able to play the “Ups” and the “Downs” as we’re not a professional trader.
The problem gets worse if you look at the “Best Days” in the market. Data in for the USA suggests that between 2002 and 2017, the S&P500 made 9.9% annually, for those who remained invested. If you missed the best days between 2002 and 2017, this rate dropped to 5%. If you missed the 20 best days, it drops to 2% and 30 best days, you lost money.
How do you get around this problem? You buy in Monthly or Quarterly, and pound-cost average yourself over the years.
Rule Nine: The 20:80 Rule
When you’re investing in the stock market, you need to accept that a few investments will drive the vast majority of your returns. Suppose you build a portfolio of 20 stocks and ETF’s. Three or four positions will drive 80% of your returns. The problem is working out which stocks are likely to drive returns.
Making money is about avoiding losing money on bad trades, not chasing returns by trying to earn returns on every trade. Often, stocks will do very little for long periods, only substantially increase in value in a short period of time.
Rule Ten: Winners Keep Winning
Winners generally keep winning. Retail investors generally feel that as the share price goes higher, it gets more and more expensive. However, this is not the case. Share price does not equal valuation.
For example, Diageo plc, the British multinational beverage alcohol company, between 2015 and 2019, its share price went from 1700 to 3500, a massive 48.57% over the four years. While Diageo’s share price increased substantially, it was much cheaper from a valuation point of view in 2019, than it was in 2015. This is down to its Price-To-Earnings ratio, which contracted substantially over the four years due to the earnings growth.