On any given day in the market, there's a decent chance that a small handful of stocks will either skyrocket or plummet. On those days, investors who had been positioned correctly before the move can see tremendous returns. That makes it very tempting to try and seek out such opportunities before they happen. After all, if you're successful at it, you could turn a little bit of money into a decent nest egg in almost no time at all.
The problem is that those moves are easier to identify after they happen than before they do. Get it wrong, and your nest egg will evaporate instead of grow. Chase after that performance, and you're likely to wind up burned and broke. The market can be a tremendous wealth generating device, but it can also burn you if you're not careful. So stop trying to “get rich quick,” and update your investing strategy instead. The five steps that follow outline a much better way to invest your money.
Step 1: Plan based around when you'll need your money
By investing, we all commit money today in the hopes that it will turn into more money in the future. The problem is that there are no guarantees when it comes to the market, especially in the short term. As a result, a smart investing strategy only allows you to invest in stocks if that money is not needed to cover costs within the next five years.
Money you need sooner belongs in cash, CDs, or duration-matched Treasury or investment grade bonds. No, you won't earn a ton of cash on that money, but there will be a much higher likelihood that the money you expect will be there when you expect it to be. That's an important part of being able to pay your bills when they come due.
This is important not just from the perspective of being able to pay your bills, but also to help you with the mental game of investing. When the market moves against you, it's a lot easier to make rational decisions regarding money you don't need for several years than it is if you're dealing with money you need to cover tomorrow's bills.
Step 2: Realize what a stock really is
While you're probably buying stocks because you hope you'll make money from them, you should recognize that what you're really doing is buying small portions of companies. As a shareholder, your long term returns will be driven by the long term prospects and results of the company.
In the short term, well, the market can be an emotional rollercoaster. You can't really predict what the market will do tomorrow, but you can use its wild swings to your advantage. The key is to build a good estimate of what the company behind the stock is really worth and let the market's price compared to that estimate drive your buy, sell, or hold decisions.
When the market makes a company's shares dirt cheap compared to that estimate, then it might be a good time to buy more shares. When the market makes it very expensive, then selling the shares you own might be a better idea. When it's in between those two extremes, then holding on might very well be the best thing to do.
Step 3: Learn how to create those fair value estimates
Ultimately, what companies are really worth depends on how much cash they generate over time. The market attempts to project the company's future cash flows and reflect that in its share price. Predicting that future is hard, and we're all likely to get it wrong, which is one reason why the market can be so volatile. Fortunately, while the prediction is hard, the math is straightforward — all it takes is a discounted cash flow model.
Imagine a company that will generate $1,000,000 one year from now and then close its doors forever. If you expect a 10% return on your money, you'd fairly value it at around $909,090.91. Why? Well, because that's the price you'd pay today to get a 10% return a year from now. If the same company would take two years to generate that cash, then you'd only be willing to pay around $826,446.28 for it. You get there by discounting the million by 10% twice — to represent the two year wait until the payoff.
Of course, most companies aim to continue to operate for the long term future. To make that work with a discounted cash flow model, you simply add up all its future years' estimated cash flows, each discounted back to what it's worth today.
Yes-it's all estimates and projections, but the magic happens when you build a model based on reasonable estimates and the company winds up looking cheaper than it's really worth. That's when you're able to get yourself in the mindset of “buy low, sell high” and can start making intelligent buy, sell, and hold decisions for yourself, regardless of what the market is doing.
Step 4: Diversify your holdings appropriately
Because each company's future is uncertain, and because once you lose your money it's gone for good, it's important to spread your investments out across multiple companies in different industries. Done right, diversification like that is the closest thing to a free lunch in investing.
When you're thinking about portfolio diversification, it's important to remember that every investment should be worth owning on its own, even as you cast a broad net for the companies you're buying. This is because diversification can quickly become a problem if it becomes the primary focus of your investing journey. Not every company is worthy of owning, and if you buy an otherwise bad investment just because it helps diversify your holdings, you still have made a bad investment.
Step 5: Review and repeat
Once you have a portfolio of great companies, you're well on your way to a much more successful investing strategy than when you were simply looking to get rich quick. Your job is not done, however. You need to regularly review your holdings and decide whether they're still worth holding. In addition, as you come up with new cash to invest, you have the opportunity to find a place for that money — either among your existing holdings or by finding new ones.
As you're reviewing your investments, you should consider updated prices and prospects when determining whether to buy more, hold on to what you have, or sell. After all, the market is forward-looking, and its (new) current value should be based on its (new) future prospects, no matter when you're looking at those prospects.
This works better than your typical “get rich quick” scheme
These five steps may not sound as exciting as a scheme pitched to you with promises of instant riches, but they have a key advantage: they have actually worked to build wealth over time. You won't get rich quick by following them, but you will have a much better chance of turning the nest egg you have into a larger one over the course of a decently long investing career.
The reality is that successful investing takes time. So get started now, and improve your chances of putting enough time into it to let your money grow to where you can get the substantial nest egg you may only dreamed of having.
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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.