Eight Stock-Investing Tips from Morningstar Analysts

I had the pleasure of being the lead writer and editor of three just-published Morningstar books on stocks--How to Get Started in Stocks for beginners, How to Select Winning Stocks for those looking to dig into individual companies, and How to Refine Your Stock Strategy for those who've been running their own portfolios for a while. In the course of writing some of the chapters for these books, I came up with a list of stock-investing tips that boils down our collective experience and insights here at Morningstar. Here are some of those tips. Whether you're a beginning or seasoned investor, these tips and commentary can provide a useful framework for your investing strategy.

1. Keep It Simple.
Contrary to what the financial media might say, keeping it simple in investing is not stupid. There is nothing wrong with buying and holding stocks for the long term, as long as you buy the right companies and are patient enough to wait for good prices.

Those who trade too often, focus on irrelevant data points, or try to predict the unpredictable are likely to encounter some unpleasant surprises when investing. This is also true of people who invest in things they don't understand. Don't get too fancy with your stock-investing strategy, and stay within your circle of competence.

2. Have the Proper Expectations.
Are you getting into stocks with the expectation that quick riches soon await? Hate to be a wet blanket, but unless you are extremely lucky, chances are you will not double your money in the next year by investing in stocks. Such returns generally cannot be achieved over a short time period unless you take on a great deal of risk by, for instance, buying extensively on margin or taking a flier on a chancy security. At this point, you have crossed the line from investing into speculating.

Though stocks have historically been the highest-returning asset class, this still means returns in the 10%-12% range. We obviously aim to achieve higher returns with the real-money Tortoise and Hare portfolios I run in the Morningstar StockInvestor newsletter, yet we're shooting only for an extra couple of percentage points. (But compounded over time, those few extra points can add up to big bucks.)

Stocks by their very nature are volatile creatures. If you don't have the proper expectations for the returns and volatility you will experience when investing in stocks, irrational behavior--taking on exorbitant risk in get-rich-quick strategies, trading too much, swearing off stocks forever because of a short-term loss--may ensue.

3. Be Prepared to Hold for a Long Time.
In the short term, stocks tend to be volatile, bouncing around every which way on the back of Mr. Market's knee-jerk reactions to news as it hits. Trying to predict the market's short-term movements is not only impossible, it's maddening. It is helpful to remember what Benjamin Graham said: In the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company.

Yet all too many investors are distracted by the popularity contests that happen every day, and then grow frustrated as the stocks of their companies--which may have sound and growing businesses--do not move. (Witness the performance the past couple of years of the three stocks I talked about in my last article:  Coke (KO),  Microsoft (MSFT), and  Wal-Mart (WMT).) Be patient and keep your focus on a company's fundamental performance. In time, the market will recognize and properly value the cash flows that your businesses create.

4. Tune Out the Noise.
There are many media outlets competing for investors' attention, and most center on relaying and justifying daily price movements of various markets. This means lots of prices--stock prices, oil prices, money prices, frozen orange juice prices--accompanied by lots of guesses about why prices changed. Unfortunately, the price changes rarely represent any real change in value. Rather, they merely represent volatility, which is inherent to any open market.

Tuning out this noise will save you time, and it will help you focus on what's important to your investing success--the performance of the companies you own. It's no accident that we spend little ink here at Morningstar discussing stock prices, yet talk extensively about the long-term positioning of the firms we cover.

And just as you won't become a better baseball player by staring at statistics sheets, your investing skills will not improve by looking only at stock prices or charts. Athletes improve by practicing and hitting the gym; investors improve by getting to know more about their companies and the world around them.

5. Behave Like an Owner.
If you are buying businesses, it makes sense to act like a business owner. This means reading and analyzing financial statements on a regular basis, weighing businesses' competitive strengths, making predictions about future trends, as well as having conviction and not acting impulsively.

6. Buy Low, Sell High.
If you let stock prices alone guide your buy and sell decisions, you're letting the tail wag the dog. Stocks are not just trading vehicles; they represent ownership interests in companies. Yet many people buy stocks just because they've recently risen, and those same people sell when stocks have recently performed poorly. Wake-up call: When stocks have fallen, they are cheaper, and that is generally the time to buy! Similarly, when they have skyrocketed, they are high, and that is generally the time to sell! Don't let fear (when stocks have fallen) or greed (when stocks have risen) take over your decision making.

7. Watch Where You Anchor.
Anchoring is a concept from the burgeoning field of behavioral finance that refers to our tendency to mentally cling to a specific reference point. Unfortunately, many people anchor on the price they paid for a stock and gauge their own (and their companies') performance relative to this number. Where a stock was last week, last month, or last year is irrelevant.

It's also helpful to remember that things change at companies. Management teams change, business models change, and economics change. For instance, if you wrote off an investment awhile ago because you thought management was shady--but management was recently replaced--don't forget to update the mental rolodex. Remember, stocks are priced and eventually weighed on the value of the future cash flows businesses will produce. Focus on this.

8. Remember that Business Economics Usually Trump Management Competence.
When considering a stock for purchase in our StockInvestor portfolios, it's no coincidence the first thing we look at is a company's economic moat, not quality of management. Just think, you can be a great racecar driver, but if your car has only half the horsepower as the rest of the field, you are not going to win. In racing, the driver's skill is important, but equipment quality trumps it.

Plus, management can (and often does) change quickly, while the economics of a business are usually much more static. Given the choice between a wide-moat cash-cow with mediocre management and a no-moat terrible-return business with bright managers, take the former.

Though this is only a portion of the tips, I firmly believe that following them will improve your stock-investing returns. To learn more about the Investing Workbook Series: Stocks, click here.