Investment Lessons for the New Year

 | Jan 03, 2012 | 11:00 AM EST  | Comments
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Today is the first trading day of the new year, and the market seems to have kicked off in grand fashion. It seems like only yesterday that 2011 was getting under way. While I'm not a big fan of New Year's resolutions, today does mark the beginning of a new investing year. For many investors, it's an opportunity to learn from or improve on 2011.

Lesson 1: Volatility is Your Friend

Investors often mistake volatility for risk. As a result, volatility has eroded the value of a portfolio. Risk, as I define it, is the probability of suffering a permanent loss of capital. Volatility, as I define it, is the movement in a stock price. Viewed this way, investors can take advantage of volatility to buy shares at better prices. I used volatility in 2011 to buy more Goldman Sachs (GS) when shares traded below $90. I first bought shares around $115 as I feel the true intrinsic value of GS is around $200. When Mr. Market gave me a chance to buy shares, I took advantage.

With Europe still in trouble and the U.S. economy far from healed, volatility will most likely be a part of 2012. Investors armed with patience and conviction will be those most likely to take advantage of Mr. Market's wild gyrations. Those looking to get in and out of stocks quickly can be hurt badly by volatility. So holding a stock for a year or more is not really as long as it appears.

Lesson Two: Know How the Business Makes Money

It's surprising to discover that many investors hold positions in businesses where they haven't the faintest clue as to how the company makes money. Knowing how a business makes its money is absolutely necessary and there are no shortcuts. Since a company's value most often hinges on the cash flows it produces, knowing how those cash flows are generated is an integral part of investing.

I know that Chipotle (CMG) makes its money from selling more and more burritos and tacos. Apple (AAPL) grows its profits by selling iPads, Macs and iPhones. Apple then makes more money when those buyers purchase apps from the App Store. When I see long lines at Chipotle, it doesn't take a MBA to figure out they are making lots of money. When I see few people shopping at Sears (SHLD) and more people at Wal-Mart (WMT) and Target (TGT), it doesn't take much to figure out that Sears might be in for a tough time. Understand how a business makes money and you will be able to figure out quickly if it can continue making money easily or have a hard time. From there it's easier to determine if a stock should be owned or not.

Lesson Three: Hit Singles and Doubles, Not Home Runs

If you have yet to see the movie Moneyball, go see it. Better yet, read the book by Michael Lewis. In the film, Oakland A's General Manager Billy Beane learns quickly that the value of a baseball player is in his on-base percentage. Thus, a player's value derives from getting on base often, not necessarily hitting lots of home runs. Investors who are constantly on the lookout for home-run stocks are going to strike out more often than investors who seek easy pitches to hit singles and doubles.

I have yet to encounter an investor who has annualized 10% to 15% a year over a period of years who is poor or out of work (Bernie Madoff earned consistently smooth returns, but that's not the same thing). Yet there are home-run hitters who have fizzled. Remember Long-Term Capital Management LP? Or Amaranth Advisors, who amassed $9 billion in assets betting big on natural gas futures? One bad bet in 2006 cost that firm $6 billion -- $5 billion in a single week -- and then it was history.

Whether you're an investment pro or a personal investor, it never hurts to pay attention to the basic principles of sound investing. Twelve months from now, those basic principles are likely to result in market-beating results, a feat that is not easy to accomplish.

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