Stock Tips You Can Use in 2004

With the Dow topping 10,000 and the financial media churning out "What's in Store for 2004?" stories by the dozen, I thought this week might be a good opportunity to take a step back and look at what really matters when it comes to investing. Needless to say, it's not the predictions that any "expert" might make in a magazine or newspaper article about macro stuff like the direction of the market or the economy. No one knows where the S&P 500 or interest rates will go next year, and while those kinds of prognostications might make for fun reading, they hardly constitute investment advice that you should take seriously.

For example, at about this time last year, the Mortgage Bankers Association was forecasting a moderate year in the mortgage market during 2003. As the main trade group for the mortgage industry, the MBA predicted that Americans would take out about $1.8 trillion in real estate loans during the coming year. Given how hot the housing market had been, and how low rates were in 2002 relative to historical levels, it was not an irrational or illogical assumption. It sure turned out to be wrong, though. Rates dropped even further in the first half of 2003 amidst rumblings from the Fed about deflation, and it looks like we'll end 2003 with about $3.4 trillion in mortgage originations--about twice what these experts had originally expected. Remember this the next time you hear someone predicting anything as complex as interest rates, the economy, or the level of the overall market. Don't accept any forecast without a huge grain of salt.

So, what should you expect the market to do in 2004? I don't know, but I do know that the basic principles behind smart investing will be the same next year as they were this year. Following are four of the most important.

1. The last shall be first, and the first shall be last. You'll have more success in investing if you look at the stocks that the market has discarded--if only temporarily--than if you chase whatever's popular at the moment. When you're reading all those year-in-review articles over the next few weeks, don't look at the top of the performance tables for investment ideas. Instead, look at the bottom. More than a few smart investors find stocks by just scanning the list of 52-week lows every day.

2. Selling is not shameful. When you think about the tax implications of selling stocks, the IRS essentially pays you to sell your losers. Yet most of us hang onto our stinkers for way too long in the vain hope that time will heal our investing mistakes. Our egos interfere with making logical investing decisions because we don’t like to admit that we're wrong, and selling is a clear admission of fault. So, instead of focusing on how much money you've made or lost on a stock, look at your portfolio afresh on a regular basis. Ask yourself whether you’d buy each stock again if you were starting with 100% cash. If the answer is no, you should think long and hard about whether that stock belongs in your portfolio. (Of course, if you’re sitting on a large capital gain in the stock, you may have a very good reason not to sell--taxes are a real cost, after all.)

3. Your biggest enemy is closer than you think. Unfortunately, the biggest enemy to investing success is not hedge funds, the Fed, or day-traders. It's ourselves. As my colleague Brian Lund trenchantly pointed out in a recent column, we're all riddled with psychological biases that hamper smart investing. Learn what these biases are, so you can recognize them in yourself and avoid them whenever possible. The field of behavioral finance has produced a wealth of research into the psychological traps that snare investors, but as a starting point I'd suggest the book Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich.

4. Homework and discipline pay off. Investing successfully is hard. We have empirical evidence of this fact in the (very) small number of professional investors who consistently beat the market, and in the wealth of studies that show that the average investor far underperforms the average investment. Most investors do not adequately research their investments (this is by far the most common answer I get when I ask people about their biggest investing mistake) and they don’t wait patiently for an appropriate price. However, both of these problems are easily fixed with some time spent researching the stocks you want to buy. One easy trick is to simply force yourself to read the 10-K--or at least the annual report--of every company you think you might want to purchase. This takes time, but it also gives you a cooling-off period that will likely help you avoid some ill-considered buys.

Have a safe and happy holiday. See you in 2004.

Shameless Plug
Morningstar's first full-length book on stock investing will hit the shelves of your favorite bookstore on Jan. 2, and is currently available for preorder on BN.com and Amazon.com. (You can also order it directly from Morningstar.) It’s titled The Five Rules for Successful Stock Investing, and it was written by yours truly in conjunction with Morningstar's stock analyst staff. The first half of the book covers the basics of fundamental analysis: Developing an investment philosophy, a mercifully short introduction to reading financial statements, a primer on valuation, and a guide to evaluating company management and assessing economic moats. The second half is a series of chapters on each sector of the market--from hardware to health care to banking--that explains industry jargon and helps you analyze complicated companies.