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7 Things You Should Know About Investing

By Dan Stone

Buy good quality common stocks and hold 'em until they go up. If they don't go up, don't buy 'em.
-- Will Rogers

The article "Mind Over Money" in the January 2002 issue of Reader's Digest, offers seven valuable insights into the psychology of investing, touching on everything from the dangers of information overload in an online world to the importance of understanding the risks that come with owning stocks.

To go the extra mile, here are seven more ideas to consider if you're someone who takes investing seriously...

# Investing Is a Choice
# It's a Market of Stocks, Not a Stock Market
# Know the Three Big Ifs
# Your Edge
# Cash Is King
# Be Contrarian
# Have the Courage of Your Convictions

1. Investing Is a Choice
You can "beat the market" (and most professional money managers as well) if you truly understand investing. What most people consider investing is really just speculating, and there's a world of difference between the two.

If you buy stocks for "a quick pop," you're not an investor; if your time frame is measured in months rather than decades, you're not an investor. If you don't know the underlying fundamentals of a company and its financials, you're not an investor. This doesn't mean you can't make money -- it just means you're playing the game, not the odds.

As an investor in stocks, you are making a choice. You are making a commitment to ignore the seemingly easy money of the "hot" stock (which might not be so hot), in some business you kinda, sorta understand but that didn't seem to matter much anyway because you were just in it for a quick profit. Once you're out of the speculating game, once you insist that your future wealth shouldn't be part of a game, you're halfway home.

2. It's a Market of Stocks, Not a Stock Market
Everyone is focused on what the market is doing -- whether it's the Dow Jones Average or the S&P 500 Index or the NASDAQ Composite. The underlying implication is that stocks march to the same drummer, rising and falling together.

Certainly, all stocks react to the same outside influences, such as economic growth, interest rates and exchange rates. But each stock reflects the valuation of an individual company, and each company has its own unique risks and opportunities.

Predicting the direction of the Dow or the S&P is more difficult than it seems at first. For one thing, knowing where interest rates are heading is an elusive skill, the abundance of expert opinions notwithstanding. For another, you don't know what the true earnings of an index really are. Which are more accurate: reported earnings or operating earnings? "Bottoms up" estimates or "top down" estimates?

Legendary investor Warren Buffett pays no attention to the level of the market in deciding which stocks to buy or sell -- and neither should you.

3. Know the Three Big Ifs
- Stocks offer better potential returns than bonds or cash if you buy them for the long term.
- Time can be your greatest ally if the companies you own have predictable growth.
- Predictable long-term growth is rare but attainable if your companies have sustainable competitive advantage.

4. Your Edge
Great businesses have one thing in common: They each maintain an advantage over their competitors. This advantage is the source of their success; it is what separates great companies from the host of pretenders.

One type of competitive advantage is a cost advantage -- namely, a company that operates more efficiently than its competitors. The other major category of competitive advantage is a quality advantage. If a product is truly better, or even thought to be superior, consumers will pay more for it.

Finding a company with a competitive advantage is not enough, however. You must also determine that its advantage is sustainable. If the company has a lower cost structure, is there a way that its competitors can catch up? If the company has a superior product, can the product be duplicated?

5. Cash Is King
Once you've narrowed your list of possible purchases to those few with competitive advantage, give some thought to what their stocks are worth. For this, your focus should be on cash flow, not on reported earnings.

The earnings that a company reports each quarter are precise -- they're just not terribly accurate. These earnings are determined by accounting rules, some of which don't reflect reality and others of which get twisted to reflect a false reality.

Reported earnings can be useful to an investor, but what really matters is cash. When you buy a stock, you put up cash. In exchange, for as long as you hold that stock, you own a piece of a company's future. You have a claim on a stream of future cash earned by that company. The challenge is in making a reasonable estimate of how significant that cash flow will be.

When you analyze financial statements, pay particular attention to the Statement of Cash Flows in a company's annual filing (known as the 10-K), which reviews results for the prior three years. Look at the "net cash provided by operating activities" and subtract the "capital expenditures" (sometimes called the "expenditures for property, plant and equipment"). This is a company's free cash flow, which will give you a pretty good idea of a company's financial success. If nothing else, you want to make certain that the free cash flow has been positive over the past three years.

6. Be Contrarian
The goal is to find stocks that are out of favor. At any given time, stock prices are driven by fear and greed, and both emotions tend to the extreme. When people are most afraid the greatest opportunities make themselves available.

To help identify a potentially good investment, look up a stock quote at quicken.com, then click on "Analyst Ratings" in the left column to see how many Wall Street analysts are recommending that stock.

As a practical matter, look for stocks where the "Strong Buys" are fewer than the "Holds." These are the stocks that are more likely to be underpriced and more likely to surprise on the upside.

7. Have the Courage of Your Convictions
For most people, this is easier said than done. But as a true investor, you have two advantages. First, by focusing on great companies, you can have confidence when the news is anything but reassuring. You can give these companies the benefit of the doubt.

Second, if you invest a certain amount every quarter or every year (known as dollar cost averaging), you will automatically be buying more shares when stock prices are low and fewer when prices are high.

Decide how much of your savings you want to invest in stocks and how much you are comfortable adding each year. For suggestions concerning asset allocation and your personal finances, you can access the interactive My Financial Plan feature at WealthEffect.com.

Will Rogers wasn't too far off the mark. You should buy good-quality stocks, and hold them. And if they don't go up, be ready to buy more.

From Readers Digest published on March 05, 2010, 9:46 AM EST