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Tuesday, August 2, 2011

My 6 Golden Rules In Investing

My 6 Golden Rules In Investing 
After more than a decade and a half of being a semi-professional investor, here are 6 golden rules that have prevented me from losing money and helped me make nice profits in the stock market.
Rule 1: Only invest when there is low downside & high upside
I only invest when there is a very low downside to a stock, but extremely high upside potential. In late 2008-2009, Best world International (Singapore based health & beauty company) saw its share price fall from a high of $1+ a share to just $0.18 because of the financial crisis.

At this price, there was virtually not much more downside. After studying the company’s financials, the stock’s net asset value (NAV) per share was $0.24 and its cash value per share was $0.18. 

Which means, even if the company was to liquidate, the total cash it had (about $26 million) when distributed to all shareholders, would be $0.18 per share. In addition, the company had zero debt. So, there was almost no chance of bankruptcy.

At the same time, there was a huge upside potential for the stock. After calculating, I found that the intrinsic value of this stock was $0.78. That’s a 400% potential return. When I find such rare gems, I gobble up as many shares as I can and wait to make a fortune.

At the same time, I know many stocks that have the potential to go up really high, but also have a lot of downside potential. This is because the stock is trading way above its NAV or its intrinsic value. In such cases, I stay away from it! I rather not make money if there is a chance of losing money. That brings me to my second rule…

Rule 2: Loss opportunity is better than losing money
I have a very strict 9 step criteria for selecting stocks to buy. These 9 steps ensures that I only buy very safe stocks that have very little chance of going down, but the potential for great gains.

Are there many stocks that fail my criteria and yet go up to high levels? Of course. When Apple was $150 a share, I would not touch it as it was overvalued and there was uncertainty over its ability to sustain its great sales performance from its innovative gadgets. While many people bought the shares, I stayed away.

Apple later rose to $210 a share. Do I have any regrets? Not at all. While the share did go higher because of continued optimism, there was also a chance that it might have gone down instead. The moment there is downside risks, I never touch a stock, no matter how good the upside may be.

To me, lost opportunity is better than losing money. This principle is something I have stuck to after reading Warrren Buffett’s principle of capital preservation. While most people get excited about how much they can possibly make when stocks go up, the most successful investors always think of how much they can possibly lose if it goes down. Buffett’s has two rules on this. Rule #1: Never lose money. Rule #2: Don’t forget rule #1!

Rule 3: Make decisions strictly on rules, not emotions
Most people lose money because they buy and sell stocks based on their emotions, not their brains.

When stocks have run up too high, many amateurs are driven by fear that they have missed the boat. Not wanting to miss the opportunity to make money, they buy at overvalued prices.

Their greed also blinds them to think that stock prices will keep going up forever. Sure enough, reality sets in, prices crash and they lose their hard earned money.

When stocks have dropped to very low levels, many amateurs out of fear that stock will keep going lower, sell at huge losses. Fear also stops amateurs from buying stocks at the best times, when they are low. As a result of always buying at high prices and selling at low prices, most amateurs always end up losing money.

To be a great investor, you must have zero emotions! Strictly buy and sell based on the rules of investing. Buy stocks of great companies when prices have fallen (when everyone else is too fearful to buy) and start selling when prices are too high (when everyone is greedy and optimistic)

That brings me to my next rule…

Rules 4: Go Against the Crowd

Over the years, I have found that I have made the greatest profits when I go against what everybody else is doing. This is known as contrarian investing.

You can only make huge profits when you buy at low prices (i.e. when everyone is selling) and sell at high prices (i.e. when everyone is buying).

A classic example is in January 2009. After being hit from the financial crisis, the US Dow Jones had dropped 38% to 8,800 points and the Singapore STI has fallen 53% to 1800 points. At the time, I calculated that the PE ratio of the two markets were between 6-8 times. This was consistent with previous market lows in the last 50-year history.

That gave me the confidence that markets were near the bottom (although I did not know exactly where the bottom was). Stocks of great blue chip companies were selling 50%-70% below intrinsic value. 

So, I started buying huge amounts of shares in companies like American Express, General Electric, Proctor & Gamble and United Health. In Singapore I accumulated Singapore Exchange (SGX), Capitaland and Bestworld International.

I was so confident that stocks were at such great bargains that I wrote a book in 30-days called ‘Profit from the Panic’, that became a national #1 best-seller. At that time, many people (including professional investment analyst) criticized me, saying that the economy was far from recovery and that it was a bad time to buy. Majority of people were pessimistic and fearful and stayed away from the market.

Within 30-days of launching my book and buying a few million in shares, the stock market hit its low and staged its biggest recovery in decades. The US index rose 53% and the Singapore market rose 86% in 9 months, making me one of my biggest profits in the last 9 years. It pays to bet against the crowd.

“Be greedy when others are fearful and be fearful when others are greedy” – Warren Buffett

Rule 5: Never chase a stock. If you cannot get your price, walk away!
Another common mistake investors make (I used to make this mistake a lot) is to chase a stock as it goes higher and higher in price, for fear that they would miss the ride up.

Once you value a stock and decide to pay a certain price (which is below the valuation), stick to your decision. If the stock is above that price, wait for it to come down to meet your price. If it does not, walk away! If a stock you want to buy starts running up really fast, above your decided buy price, don’t chase it. Let it come back down or walk away.

I learnt this from street shopping in Thailand. I never pay what the shopkeepers ask. I bargain like crazy and am willing to walk away if I do not get a super deal. Although I do miss out on some items at times, I also get great deals when I stick to my prices.

Rule 6: Always Buy and Sell in Stages
This is something I learnt from studying professional fund and hedge fund managers.

You can never always buy a stock at the very bottom price (you ever know where it is) and you can never sell at the very top. 

So, instead of thinking you can have perfect timing, buy in stages, so you average the price you pay slightly up or down. For example, if I wanted to invest $100,000 in Citigroup at the current price of $3.35. I will not buy it all at one shot.

Short-term market movements may cause the price to fluctuate between $2.80-$4.50. So, I will invest $25,000 at the price of $3.35 and wait. 
If it goes down to $2.80, I will invest another $25,000, buying more shares at this lower price and average my cost down. 

If it goes up to $4, I also invest another $25,000, but buy less shares at this higher price. Investing my $100k in 4 stages assures that I can a fair average price I am looking for. 
Adam Khoo
Wealth and Investment Tips

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