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10 Basics of Investing Simple Rules Help to Minimize Your Risk

Posted on March 2, 2011 by Thomas DeGrace

Basics of investing rules that should increase your returns and help to minimize your risk. After seeing plenty of new investors lose 50% or more of their investment in the first year, I have developed 10 rules of investing.

After spending hours watching CNBC, reading daily news from the market analysts, and getting supposedly “groundbreaking” news from individual companies, it’s very easy to become overwhelmed by all the information. Furthermore, it is often the case that, rather than helping you to invest wisely, this information can actually work against you in real trading.

Rule #1 Analysts Recommendations

These analysts would appear to be doing the investment world a great service by giving ratings on different stocks. In fact, these analysts often have hidden agendas that the average investor is not aware of. Ever notice how analysts issue buy recommendations when a stock is at its all-time high and sell recommendations when stocks are at their all-time low?

Rule #2 Money Management

One of the important things to learn about investing is how to manage risk. Anyone who has no respect for risk is on the road to complete financial disaster. You often hear these great stories about the guy who turned a small amount of money into a million dollars. But what you don’t hear is that years down the road, these same people are often wiped out as a result of not respecting the risks that go with investing. Learning how to pick investments that can appreciate in both good and bad times is the key to successful investing. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points.

Rule # 3 NO CRUSHING DEBT!!!!

I have seen it a million times, an investor sees a once great company trading at what appears to be a bargain price, so he buys the stock. The company is often very well known, such as At&T, AOL, Kmart, Xerox, Lucent and Tyco, and it may even still be growing both earnings and revenue.

But these are companies that are at risk, and they will have to continue to sell off assets just to stay afloat. And don’t expect them to get anywhere near the market value in a distress sale. And, even worse, in bankruptcy, these assets go for only 20 cents on the dollar. After a bankruptcy, typically all common shareholders receive nothing and ownership of the company go to the debt holders. The debt holders can decide either to sell off assets to repay debt or to take the company public again.

If you can add 1+2=3 then you should be able to read a balance sheet. And it doesn’t hurt to check the SEC reports such as the 10-Q. The fact is that no company with zero debt has ever gone bankrupt.

The general rule we like to use is to buy stocks that have their interest expense to income ratio at less than 25%.

Rule # 4 IPO’s

Start investing in IPO’s after they begin to trade and you will be able to count the days till you are done doing that! IPO’s can start trading anywhere from 20% to 400% up on their first day of trading and go straight downhill from there until they bottom out. About 75% of all IPO’s are trading below their IPO price one year after trading.

Rule #5 Low Priced Stock Myths

Low priced stocks are not better valued than high priced stocks, and they don’t go up any faster than high priced stocks. Even in these days of free information, there is still a feeling that if you buy a stock that is trading at $5 a share, you have more upside potential than you would with a stock trading at $65 a share. Even crazier is the feeling that by having more shares, you are better off than by only having a few. In fact, it is only the company’s market cap, representing the total value of all shares, that is important when it comes to putting a value on a company.

Rule #6 Margin Trading is a Fools Game

The key to successful investing is having available cash to choose the next best investment opportunity that comes along. When you get into debt, you begin to lose your options and get trapped into your original investments. Remember that all stocks can crash, and the odds are, if you are high in margin, you will soon have a margin call in which you could lose 75% of your money. As a general rule, buying stock on margin is bad money management. The fact is that 90% of margins players get margined out.

Rule #7 OTC Stocks

OTC or penny stocks defy all logic as they move up mostly on hype instead of actual net profits.

There are 2 main ways OTC stocks move up rapidly.

1. A pump and dump tactic, in which a group of people front-loads the stock, then issue a big newsletter, etc. in which they sell into the rally. After the rally, the stock moves back down almost as fast as it went up.

2. Massive PR campaigns which are used to bring awareness to an OTC stock. These campaigns work great for a while but by the time the average investor sees the stock the money runs out as the price starts to head downhill again.

Rule #8 Don’t try to hit the home run on every pick

Everyone wants to be the one to have their portfolio shoot up 200% in a short amount of time. Fact is, there is no way to achieve this without taking on severe risk. Have you ever heard of “The Tortoise and the Hare”? The rabbit has more speed, but the turtle has more determination, stamina, and consistency. The rabbit may get a fast start, but the turtle wins the race.

Rule #9 The Urge to Trade

Emotions work against you in investing and it’s very easy to want constant action. The problem is that great picks don’t come along daily. Idle periods are a natural part of a business. You should never force yourself to find a stock to invest in, because it may go against you at the worst possible time. You need to be emotionally clean and ready to take on a new investment, rather than get caught in a deteriorating position. As a rule: the more you trade, the more risk you take.

Rule #10 All Stocks Can Crash

This is a hard lesson to learn for new investors who ride out a single stock only to see it crash later on. As we have seen recently, even great stocks like Microsoft, Cisco, Citigroup and Home Depot have all crashed. While these stocks are likely to hit their highs again in the future, they, just like any other stock, are bound to crash sometime, no matter how great the company is.