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September 30, 2011

Before you ever buy a single stock….

Today, two close associates both asked me my advice on “the stock market” (I won’t say “investing in”, see below). One had seen a late night infomertial advising him to “short the S&P NOW” and wanted to know how to buy put options. I told him the basics of how to do that, and then why he should absolutely not do that. Then my other friend asked me something similar so I sent them both the following:

Before you ever put any money into the public markets you need to have the following down cold, or YOU WILL LOSE YOUR MONEY

1) Investment objectives: you need to know what you are out to do. “Make money” isn’t it. Do you want to buy companies cheap that will appreciate at a decent rate over time? Do you want to build up a nice stream of dividend income every month? Do you want to buy low and sell high? Do you want to short stocks?

Biggest decision: You have to decide if you are going to be an INVESTOR or a TRADER.

An investor will step in a buy things when he thinks the underlying value of the asset (company, stock) has diverged from the current price.

A trader will buy something now because he thinks the price is going up.

There is a big difference here and it is key. You must know which method you are employing for each purchase before you make it. Otherwise, consider the following:

You buy company A and the stock price (as if on cue) tanks. What do you do? (There is an old joke on Wall St “My short term trade just became a long term hold”)

If you are an investor, who has calculated the value of the business to be higher than your entry price, then if nothing has changed in your assessment of the business, you gleefully rub your hands together and you buy more. (Think Warren Buffet)

Successful investors spend long periods of time under water on their investments with only their own confidence in their model to sustain them until the underlying price reverts to its intrinsic value.

However, if you are a trader, you have to admit that you were wrong and take your small loss before it turns into a big one, and move on to the next trade.

Successful traders have horrible batting averages, they are wrong more often than they are right – but they have the mental discipline to stick to their plan. Thus, they let their winners run and they cut their losses. Most people do the opposite (because after you study psychology of trading you come to understand that we are hardwired to do the opposite).

In either case, they never put their money on the line until they have a coherent plan and investment methodology which they will adhere to no matter what.

This is what separates the winners from the losers.

Get and read these books:

The Disciplined Trader & The Investors Quotient

Stan Weinstein’s Secrets for Profiting in Bull and Bear Markets

Mike Swanson’s Strategic Stock Trading

David Skarica’s The Great Supercycle

For added measure:

Sham Gad’s The Business of Value Investing

The “Little Book” series:

The Little Book of Value Investing

The Little Book of Sideways Markets

The Little Book of Safe Money

(Circling back to the late-night huckster who was advising people that the S&P was going down “hundreds of points” – I personally have a theory that the world’s most successful investors do not actually PREDICT the future. They succeed by correctly understanding the present – so people who offer to “sell predictions” are usually in the prediction selling business, not in making money in the market business)