Investing in Stocks (Part 2)

In my previous blog entry, I promised to share some rules for investing in stocks. Today I will share the first two rules, to which pretty much all experts agree.

Rule #1 – Invest long-term. In 2008, when the Great Recession struck, stocks on average lost approximately 37% of their value. An average investor who sold all of his stocks then would have lost more than one-third of his money. But if that average investor had held on to his stocks, he could have recouped all of his losses plus a little extra by the end of 2012.

Investors measure overall stock market performance using several stock indexes. A stock index generally tracks the price movement of selected stocks. The four major stock indexes are:

1. The Dow Jones Industrial Average (the Dow), which tracks 30 “blue chip” stocks. These are stocks of very successful, large, stable companies, such as Apple, 3M, IBM, and Walmart.

2.  The S&P 500 tracks more than 500 large companies, including the 30 in the Dow.

3.  The NASDAQ tracks more than 2,000 stocks listed in the NASDAQ stock exchange, which has a lot of technology companies.

4.  The Russell 2000 tracks about 2,000 smaller companies—“smaller” being a relative term, since we are still talking about companies with stock worth millions, and even billions, of dollars.

The stock indexes use formulas to calculate their respective values. You don’t really need to know how those calculations are done. The important thing to know is the direction the values are going over time, as well as how much they rise or fall.

Just before the pandemic struck in 2020, the S&P 500 stock index was at about 3400. During the pandemic it plummeted to below 2300—a drop of about one-third. Yet by the end of August it was back above 3500, and as I write this it has risen above 4100.

I heard one expert compare the stock market to a helium balloon—it’s natural momentum is to go upward. Of course, it does sometimes go down, but you don’t actually lose money until—and unless—you sell. History says stocks will go back up over time. So you should always invest for the long haul.

A corollary to this first rule is that I never invest money I think I might need in the near future, and I certainly never borrow money to invest in stocks. Stocks become very risky whenever you invest money you cannot afford to leave alone for a long time, because stocks can, and sometimes do, lose money in the short-term. You have to be able to wait out those occasional downturns. In most cases, I hold stocks for years, not days or months. (There can also be a tax advantage to holding stocks long-term, because when you sell a stock at a profit those profits are taxed as long-term capital gains rather than as ordinary income if you held the stock longer than a year. Ask your tax advisor about that.)

So I am not, and never will be, a “day trader”—that is, a person who sells a stock the same day he buys it. That just seems too much like gambling to me.

Rule #2 – Diversify. Companies occasionally go bankrupt and/or go out of business. Enron, for example. And many companies go through rough patches. You can minimize your risk by investing in many different companies, as your resources allow. That way, even if you get unlucky with one company, you’ll still be fine overall. Experts recommend that people invest in at least 15 stocks in order to be sufficiently diversified. Until you can do that, you are probably better off with a mutual fund and/or an ETF.

You should also invest in different types of companies. For example, don’t invest all of your money in insurance companies, lest the insurance industry suffer a catastrophic year. Instead, invest in banks, too, as well as manufacturing, retail, technology, etc.

Next week we’ll talk about some other rules for investing in stocks, like what to buy and when to sell—rules that are a bit more subjective, but that have worked well for me.