Successfully playing the stock market — like chess—is never about going for broke.
Many investors like to use analogies from sports or the military to describe their investment approach, so they’ll often use the phrase playing the stock market. But if I had to compare our investing approach to anything outside the investment business, I’d choose chess.
Good chess players never “go for broke”, as the saying goes. Instead, they try to position their pieces so they can profit from the mistakes they expect from opponents who are less talented, less experienced or less patient.
Successful investors follow a comparable approach. But the crucial difference is that they have no opponent who can be relied upon to make mistakes.
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Instead, successful investors try to arrange their portfolios so that they more-or-less automatically tap into the profit and long-term growth that inevitably come to well-established companies operating in relatively free economies in relatively prosperous times.
Four key points to sum up the basics of successfully playing the stock market
At the same time, it’s essential to diversify, as you do if you are investing your money with our three-pronged investment approach of investing in well-established companies, spreading your investments across most if not all of the five economic sectors and avoiding stocks in the broker/media limelight.
In addition, successful investors need to limit their involvement in trouble-prone areas like new issues, start-up companies and illiquid investments.
They need to stay out of companies in which they have doubts of any sort about the integrity of insiders.
They also need to recognize the special risks of investing in fashionable or excessively popular minefields, such as Internet stocks in the late 1990s, or income trusts in the 2000s, or today’s social media stars, led by companies like Twitter or Groupon.
In fact, you could sum up the basics of successful investing quite simply in four key points:
Don’t depend on luck to make money for you or to prevent losses.
Be skeptical of the claims and recommendations of brokers, promoters or anybody else with a vested interest in a particular investment.
Don’t do anything stupid.
Win by not losing.
How many stocks should you hold in your portfolio?
You’ll hear all kinds of advice pertaining to the number of stocks you should hold in your account when you start playing the stock market. We recommend that you should invest initially in a minimum of four or five stocks—one from each of most, if not all, of the five main economic sectors (Resources & Commodities, Finance, Manufacturing & Industry, Utilities and Consumer).
You can buy them one at a time or over a period of months (or even years), rather than all at once. After that, you can gradually add new names to your portfolio as funds become available, taking care to spread your holdings out as we recommend.
When you get above $200,000 or so, you can gradually increase the number of stocks you hold. When your portfolio reaches the $500,000 to $1-million range, 25 to 30 stocks is a good number to aim for. For a mature portfolio, 40 stocks is a good upper limit.
Of course, you may fall a few stocks below that range, or go a few above it, particularly when you’re making changes to your holdings. That won’t matter if you follow our three-part prescription of mainly investing in well-established companies; spreading your money across the five main economic sectors; and downplaying stocks that are in the broker/public-relations limelight.
There is a reason why our upper limit for any portfolio is around 40 stocks. Any more than that, and even your best choices will have little impact on your personal wealth.
Be smart while playing the stock market and avoid diluting your profits with mutual funds
Some investors prefer to hold stocks through mutual funds. However, many fund investors routinely hold more than 40 stocks through their fund holdings. That’s because they often invest in 10 or more individual funds, any one of which may hold 50 to 100 stocks. There’s a lot of overlap in stocks between funds, of course, but this still represents far too much diversification. That’s why we continue to recommend that you hold no more than five funds.
When you hold more, you spread your money out too thinly and condemn yourself to mediocre results, at best. The best you can hope for is a long-term return that more or less equals the market, minus the average MER (the yearly cost of investing in most funds) of 2.5% to 3%. Mind you, that’s what you get if you invest only in well-managed funds.
All of these points relate to our analogy of the intelligent chess player’s approach to investing. Successful investors playing the stock market will set up a portfolio that can tap into the best opportunities in the market, under all market conditions—instead of just reacting to events in the market and the economy and hoping you’ve made the right moves.
Are you a new investor who has just started playing the stock market? What other topics would you like to hear about? Share your thoughts with us in the comments.
This article was originally published in 2017 and is regularly updated.
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