Wise Investment Disciplines for Buying Stocks

One of the biggest things that separates good investors from bad investors is discipline. There is a lot more to investing than buying a stock that you like or that your advisor recommends. You have to use discipline when buying anything. If you don’t it will cost you a great deal of money.

First of all, I would only recommend buying a stock thatI see value in at the current price. Warren Buffett, who is considered perhaps the greatest investor of all time, says, “I would rather pay a fair price for a wonderful company than pay a wonderful price for a fair company.” Buying “value” is the foundation of fundamental investing. How do you determine the value of a stock? You first look at the company’s financial statement. Are they a financially sound company or is the company on life support? What is the market for the company’s products or services? Then, how does the current stock price compare to its peers?

When you compare stock prices to find value, you aren’t looking for the dollar amount that the stock trades at, you are looking for the multiple (P/E or price to earnings) that the stock trades at. The P/E is the “real” price of the stock and will tell you whether it is cheap or expensive. Focus on the price per earnings, not the price per share.

Price to book is another great tool to help you find value. The book value is the based on the company’s assets and liabilities. Basically it is the net worth of the company. Occasionally you can find great deals where a good company is priced below book value. These are true value opportunities!

Finally, when you identify a stock that you want to buy you need to apply buying disciplines that will help you identify lock in profit margins, get better pricing, and save you some short-term pain if the stock declines. First, always use limit orders. Limit orders allow you to put a maximum price that you are willing to pay. That way you don’t overpay for the stock. Another discipline to use when buying is to buy in segments. In other words don’t buy your whole position at once. If you want to buy 500 shares of XYZ, start your position with 100-200 shares. That way if you are early, you don’t take as big of a beating as the stock falls, and you can accumulate more on the way down and lower your cost basis.

A great example is about a month ago I mentioned on my newsletter that I liked CBOE. It was trading around $26 at the time. The stock has since dropped to near $20. If you bought all 500 shares at $26 then you would be down about $3000 right now (ouch). However, if you bought your first 100 shares at $26, another 100 at $24, another 100 at $22, and 200 more at $20 (assuming it goes to $20), you would have the same amount of shares but your cost basis would be $22.40 and you would only be down $1200.

You also benefit on the upside by using this discipline. If you bought all 500 shares at $26, the stock has to rise above $26 before it becomes a profitable investment. However, if you applied the averaging down method, it becomes profitable when the stock is over $22.40. At $26, the price you originally wanted 500 shares at, you are now up $1800, and can now sell half of your position, locking in profits, and hold on to the rest. It the stock continues up, you are still making money, but if the stock falls, you can start the buying process over again.

There is no investment that you absolutely have to have! When investors let their emotions get in the way and they feel like they will miss out if they don’t buy a certain stock they end up chasing it, and pay too much money. This is the same thing that creates bubbles that blow up in investor’s faces. Use these buying disciplines and you will be a much more successful investor.