This is the first installment in a series about the key rules I follow when it comes to investing
- Paying Taxes Isn't Always Bad
As long as taxes have existed, people have hated paying them. But take my advice: you should never be afraid of paying taxes on stock gains!
Some people get unnecessarily stressed when they’ve invested in a stock, and are then told they need to sell it. All they see are the taxes they’ll have to pay because the gains were short-term. They feel there’s no point in making money in a short period of time when it means you will have much less to show for it than if the stock were held long-term.
But that’s not a rational way of thinking. I’m here to tell you it’s OK to pay the taxes. I’ve made peace with the necessary process of paying taxes, because I know that some gains are unsustainable.
So many people have it in their heads that if you buy and hold, you always end up with more than if you buy and sell, so it’s often difficult to get this point across.
Look at it this way: if you hold on to a stock to get the long-term price, and then end up with no gain at all, you won’t have to pay taxes since you’re selling at a loss. But you don’t want to avoid paying taxes the hard way, do you?
It’s important to remember that any gains in the stock market can be fleeting. Because of that fact, it’s better to stop worrying about having to pay taxes and take the gains when they appear unsustainable in the long term (check with a financial professional about this). Otherwise, you could be riding things back to a loss and end up with nothing at all.
So bite the bullet and pay the taxes. You’ll most likely end up with far more of a gain than you think.
2. Buy Damaged Stocks, Not Damaged Companies
Wall Street merchandise isn’t returnable. If you buy into a company due to an enticing price drop and later find out it has serious problems, you’re out of luck.
That’s why it’s important to always do your homework before you buy. Sometimes it’s easy to discern which companies are permanently damaged versus those that are having temporary issues.
But other times, it’s not so cut and dried.
If you see a stock experience a sudden dip in price, take some time to find out why before buying into it. If it’s an entity that’s been defrauded by its own management company, (which definitely happens!) then run the other way—it’s probably damaged goods may never fully recover.
But if its a company that’s simply experiencing a shortfall because of a fixable problem, then a temporary point drop could be a prime opportunity for you to invest. When the company recovers, you’ll be glad you took advantage of the bargain opportunity.
3. Diversify, diversify, diversify!
Having all your eggs in one basket is never a smart way to go. Here’s a proven statistic for you: sector risk accounts for about 50% of the entire risk in owning a stock.
What is sector risk, exactly? It’s the danger that the stocks of many of the companies in one sector (like health care or technology) will fall in price at the same time because of an event that affects the entire industry.
That’s why you should never have too many stocks within the same sector. Diversification is the only investment concept that really does work for everyone. If you can create a good mix of several different sectors in your investment portfolio, you’ll never be completed blinded by a stock market storm (which happens more often that you may think).
So why don’t more people follow this simple rule of diversification? Many stock market newbies simply don’t understand what stocks they’re buying. They end up with stocks that are strikingly similar because they don’t even realize they’re in the same sector.
Failing to diversify your portfolio isn’t just a rookie mistake, however. Many professionals prefer not to diversify because of the strange way money is managed in this country.
While it’s true that if you concentrate all your stocks in one sector, and then that sector experiences an exceptionally profitable period you will beat nearly all the diversified funds out there. But just think about the opposite result had you concentrated all your stocks in a different sector that wound up plummeting in value. It could ruin you.
In the end, controlling risk is the key to long-term benefits, and controlling risk means always being diversified.