Masters Series: Three Rules for New Investors

Editor's note: It's a plea we hear all the time: "I'd like to manage my money, but I don't have the time. That's why I read your letters."

In today's edition of our weekend Masters Series, S&A founder Porter Stansberry explains the danger of that thinking.

In the following piece – originally published in the January 19, 2007 S&A Digest – Porter relates a conversation with a friend who was "outsourcing" his investing… And he shares three simple concepts new investors can use to start making sound decisions with their investments…

Three Rules for New Investors
By Porter Stansberry, founder, S&A Investment Research

Last week, I got a call out of the blue from an old friend who has done very well in business.

He's now the CEO of a large, private company, which, were it public, would be valued at around $1 billion. He didn't mention what he wanted to talk about, but I knew it was important. This is the kind of man who values his time and measures his words.

He'd arranged for us to have a very private table, in the back of a nice Italian restaurant. After some small talk, he picked up a plastic folder packed with papers.

"Porter," he said, "while I've done well with my company, my personal finances are a mess. I don't have time to manage my money, so I keep stuffing cash into low-return savings accounts. I've got a few stocks – mostly your picks, actually – and they've done well. But not nearly as well as your S&A 16 [model portfolio] did last year. How can I organize all of this, to finally put my money to work? Should I put all of my money into the new S&A 16?"

"Well, you could. It's a good portfolio. It's relatively diversified," I said. "But... you've bought and sold entire companies, some of which are worth hundreds of millions of dollars. You're an expert in accounting. You know more about a lot of businesses than I do, and you surely know more about accounting and valuation. Why wouldn't you put your expertise to work on your account?"

"I know you're right," he said. "But I simply don't have time. When I'm not at work, I don't want to think about money. I'm playing with my kids. The last thing I want to do is sit down at a spreadsheet and figure out what a public company is worth, what I should pay for it, etc. That's what you do. That's why I read your letters."

I have heard this explanation many, many times before. It's logical and reasonable. But it has always felt wrong to me to entrust your life savings to another person... especially if you have the means and the skills to manage your own money. No, taking on this responsibility yourself doesn't ensure success... but it ensures that you deserve to succeed.

"As you know," I told my friend, "I can't give you any personal advice. And you also know that I put my best ideas in the newsletter, which you've already seen. But I don't think you should 'outsource' your investing, to my Advisory or any other person. You have the ability to make high, safe returns, even if you only spend 10 hours per month on your investments."

"OK, OK... I know you're right. How should I get started?"

Here's what I told him:

There are three things you can do to greatly increase your chances at success, as an individual investor.

First, only invest in companies that pay a substantial dividend (say, at least 3%) and that have a long history of increasing their dividend. You may count money spent on share buybacks when measuring the dividend yield.

This will do several things for you. It will narrow your possible choices substantially, giving you an investment "universe" that's more manageable. It also will automatically prevent you from buying stocks that are speculative or overpriced. And finally, it will greatly reduce the odds that your account will ever show a loss. Earning 3% a year isn't much. But it adds up, especially if the company continues to increase its dividend. After a year or two, even if the share price dips, you'll probably still show a gain, thanks to the dividend.

Second, out of the companies that are paying a good dividend, only buy companies whose businesses you're able to easily understand and that you judge to have a solid competitive advantage. As a test of your understanding, read the company's 10K (annual report) filed with the Securities and Exchange Commission. You can get a copy online for free. Or you can call the company and they'll send you a copy.

If you're not willing to spend an hour or two reading a company's 10K, are you really ready to invest 4%-6% of your life savings in its stock? It baffles me that investors will readily pile money into companies that they don't understand... and that they make no effort to understand. (Keep in mind, I'm not talking about trading here. I'm talking about investing – buying a position and keeping it for years.)

Third, only buy stocks when they are very attractively priced, i.e. when there's a substantial margin of safety in the stock. This means waiting to buy until the company's shares are priced so low that the company could afford to buy back all of its shares.

I perform this test on all of the stocks that make it into my "no risk" portfolio – which is almost always my best-performing portfolio every year. This step makes it nearly impossible for you to lose money investing and will ensure that you garner the benefits of compounding, because your entry price will be small relative to the company's assets and future earnings.

What I've learned about finance and investing has taught me that it's very hard, nearly impossible, for anyone to beat the compound returns of high-quality common stocks held for the long term. If you follow these three rules – good dividends, understandable businesses with competitive advantages, and buying only at very safe prices – you can achieve world-class investment results.

You can do this without anyone's help (including ours) in about 10 hours per month.

Good investing,

Porter Stansberry

Editor's note: Earlier this year, Porter and his research team launched a new advisory, Stansberry Alpha, based on a single trading strategy that subscribers can use to potentially make outsized returns trading the best and safest stocks on the market. Even better, subscribers using this options strategy take on less risk than they would by simply buying stocks. To learn more about Stansberry Alpha, click here.