With the recent run up in both the stock market and the real estate market, it’s now become quite en vogue to call oneself an investor. Those who have sold their home for a profit are calling themselves investors, even when it’s the only piece of real estate they own. Others believe they’re investors because they have seen their 401k balances increase.

My concern is that what many are now calling investing is nothing more than speculating. We frequently hear stories of those that have bought properties in the so-called “hot” markets hoping to flip them for a grand profit. There is also no shortage of hot stock tips. If that’s not enough, you’ve probably at one time or another seen those ads on TV trying to get you to “invest” in gold.

So what separates an investor from a speculator? Benjamin Graham, who could be seen as Warren Buffett’s mentor, has this to say in his book, The Intelligent Investor:

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Two words here stick out to me: “thorough analysis”. So many people these days have no idea what they’re invested in much less have done a thorough analysis of these investments. Some will argue that they invest in Mutual Funds because the fund manager does the analysis for them. This can be true, but I still believe that no one cares about your money as much as you do.

Another point Graham makes here is that investments “[promise] the safety of principal and an adequate return.” This probably had something to do with Warren Buffett’s formulation of his Rule #1 of investing: Don’t Lose Money. (Remember that a 75% loss is only offset by a 400% gain.)

Speculation does have its place, but we need to recognize the difference between speculation and investing.

One of the great investors of our time is Peter Lynch. He was the manager of the famed Magellan Fund at Fidelity Investments from 1977 until 1990 when he retired.

At an investment conference in 2005, he gave a checklist of 8 fundamental principles that he used in his stock picking. I think there’s a lot to learn from the following 8 items:

1. Know what you own. This advice seems so simple, but is actually rarely followed by many investors. If you own mutual funds or ETFs, do you know what the fund is invested in or what the ETF is actually tracking?

2. It is futile to predict the economy and interest rates. Doing so is characteristic of short term and emotional trading. It can be important to understand these things, like he says, they’re difficult to predict.

3. You have plenty of time to identify and recognize exceptional companies. So many people are worried about getting into an investment at the best and most opportune time. Take your time to research and look into any investment your considering. You’ll always have enough time to do enough research if the investment is worthwhile. There will also always be another good investment. If you missed Microsoft or Google, don’t think there will never be another good investment.

4. Avoid long shots. I think it says enough.

5. Good management is very important - buy good businesses. Even the greatest business concepts can fail with the wrong team in place. Mediocre businesses can also be outstanding with the right leadership. Take Steve Jobs and Apple for instance. Look at the companies’ performance with and without him at the helm. It speaks volumes.

6. Be flexible and humble, and learn from mistakes. This is good advice not only for investing. Realize you’re going to make mistakes and make it a point to learn from them.

7. Before you make a purchase, you should be able to explain why you’re buying. If you can’t explain your reasoning, you probably don’t understand the investment, and you shouldn’t invest in things you don’t understand. Most people hear this, throw their hands up, and don’t invest. Instead, take the time to try and understand the business if you’re interested in it, and then buy it if it makes sense.

8. There’s always something to worry about. Nothing is a ever a sure thing. Don’t wait for something to be perfect, just put in your due diligence to alleviate and mitigate your risk.

We can learn a lot from these principles, especially since they come from such a successful investor. I also like a couple of Peter Lynch’s quotes. They can also teach a lot:

“Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it.”(McDonald’s is a great example of this)

“If you stay half alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them.”(Look at everyday products you and others are buying)

We can learn a lot from successful investors such as Peter Lynch. Hopefully some of his strategies will be helpful as you begin and continue to invest.

So many people want to invest but they never get started because they’re afraid of jumping into the market at the wrong time. This is a valid concern; no one wants to lose money. So what is it?

Dollar Cost Averaging is a simple technique employed to mitigate the risk of investing a large sum of money at the “wrong time”. It is accomplished by purchasing a certain fixed dollar amount of some particular investment at set regular intervals.

Because you’re always investing the same dollar amount, you’ll be buying more shares when the price is low and fewer shares when the price is higher. This strategy has an averaging effect on your cumulative purchase price that actually favors the lower price.

Let’s take an example.

We’re going to invest $500 a month in XYZ Corporation. In the first month the stock is trading at $20 which allows you to purchase 25 shares. Next month the stock is trading at $10 per share and you’re able to buy 50 shares.

At first glance, you might expect the average price to be $15, but this isn’t the case. After two months, you’ve invested $1,000 and have purchased 75 shares. This comes out to $13.33 per share. This is due to the fact that you’re not only buying shares at different prices but also different quantities.

This strategy works really well for people wanting to get started investing because they may not have a lump sum to invest in the first place. Consistent use of this strategy is a great way to reduce your investment risk.

So what’s holding you back from getting started?

Everyday we’re faced with choices, and it’s the choices we make that ultimately determine the condition of our futures.

I’m not going to leap into a long discourse about good choices and bad choices. I’m assuming that if you’re reading this you’re already making relatively good financial choices or at least trying to learn how.

I’m more concerned with the myriad of good choices and how we choose between them. This all may seem abstract, but I intend it this way. I don’t want to get into specifics here in this post.

There are many different ways to become rich. No one way is necessarily better or worse than another. What you need to find is the way that works for you.

Many people have gotten rich through real estate investing. Interestingly, there are also those who don’t believe it’s possible. This is perfectly fine because it’s not the way for everyone.

Many have also gotten rich from investing in the stock market. Others think it’s too risky and therefore avoid it. Again, it’s not for them.

Starting a business is another great way that people have gotten wealthy. Again, it’s also too risky for many.

All of these different strategies or investments are fantastic ways to gain wealth. Not all of them are right for everyone. What’s important is to find which strategy suits you and make the choice and go after it.

I’ll also say that mutual funds held in 401(k)s and IRAs are not the only way to accumulate wealth and minimize risk. They have their advantages such as tax savings, being easy to get into, and being simple to manage. They also have their disadvantages.

Find what’s right for you and try to disregard the naysayers. It’s your future and your choice.

The real estate market and the stock market. Before I get to this, let me first talk a little bit about markets in general.

A Market Economy

In the United States, we live in a market economy. The economy relies primarily on the interactions between buyers and sellers to allocate resources. Prices are generally determined by basic supply and demand.

There are many different types of markets such as flea markets, farmers’ markets, financial markets, real estate markets, stock markets, etc. Each market serves its purpose.

Financial markets exist to match those who want capital (businesses) with those who have it (investors). Stock markets are secondary markets where buyers and sellers of company stocks come together and trade. Real estate markets bring together buyers and sellers of real estate. I hope you’re noticing the pattern.

Even though all the markets bring buyers and sellers together, they are all different.

The Comparison

Recently we’ve been hearing a lot about the real estate market and how the bubble’s bursting and the market’s crashing. In February, we’ve also seen the stock market experience a little crash of its own and then recover. Take a look at the difference though.

The stock market is full of different prices, but at any given point in time there is only one stock price per company. If you want to buy a share of General Electric, you have to pay the current market price for that share. It doesn’t matter if you live in New York, L.A, Seattle or Omaha. There’s one price. When that price crashes, it crashes everywhere. When that price goes up, it goes up everywhere. Also your 100 shares of stock are exactly the same as the next guys’.

Contrast this now with the real estate market. Prices vary across the board here too, but there’s no one market price for a 3 bedroom 2 bath house with a 2 car garage. There aren’t even 2 houses exactly alike. You might find one house in California right now with a market price of about $650,000. A similar house (notice it’s not the same) in Kansas City might have a market price of $150,000.

The differences don’t just stop here though. Just as their can be a price discrepancy, the direction of the price movement isn’t linked either. Every one’s worried because of the bursting bubble right now, but if you lived in Salt Lake City you wouldn’t know what they’re talking about.

The point I’m making here is that you can’t make broad generalizations about the real estate market. There is only one stock market that trades General Electric and MacDo (that’s MacDonald’s if your new to this blog), but there are many markets that sell 3 bedroom 2 bath houses (and some places are even appreciating).

The goal of this post is not to advocate one market over another (be it stock or real estate). I’ll leave that to other posts such as Reasons I like Real Estate and Why I don’t buy Mutual Funds.

I do want to stress, however, that because the markets are different, they require different strategies. With stocks you have to figure out how to win in the one market. In real estate you have multiple markets to choose from.

[Editorial Note: This is why I don’t buy into all the media’s doom and gloom about real estate.]

I previously wrote about some of the basics of the stock market and how it works. Now I want to go over a few terms and concepts in order to understand the market better.

First of all is the market capitalization of a company or stock. If you’re familiar with mutual funds, you’ve probably heard of large or small cap stocks. A company’s market cap refers to its economic size and is determined by multiplying the stock price by the number of outstanding shares. This figure is a representation of the public’s view of the value of a company.

Large Cap stocks are typically valued at over $10 billion and small cap stocks at less than $1 billion.

When looking into individual stocks one of the most common things looked into is the company’s P/E Ratio. This stands for the price to earnings ratio. It is a measure a stock’s price relative the company’s earnings. The ratio is figured by dividing the market capitalization by the earnings, or dividing the stock price by the earnings per share (EPS). The higher this ratio, the more expensive the stock is thought to be. If the P/E ratio is 16, then you’re paying $16 for every $1 worth of earnings.

The P/E ratio is often talked about because it is a way to compare different sizes of companies to one another. It’s kind of an equalizer. In fact, ratios are often used in stock analysis for this very reason.

There’s a whole lot more to look at when you’re getting into the stock market, and I’ll probably touch on them at some point. Even if you’re more interested in mutual funds and ETFs, it wouldn’t hurt to learn about what these funds are made up of. I’m convinced that the more understanding you have, the more successful investor you’ll be.

The stock market is very well known yet surprisingly not very well understood. Hopefully I’ll shed some light on the subject, and you can fill in what I miss.

One way for a company to raise money for growth and expansion is to sell shares of stock. When you hear about a company “going public”, a previously privately held company is now offering shares of stock to the general public. You and I can now buy an ownership interest in the company. This sale of stock to the public is called an “IPO”, or initial public offering.

Important to note: This is the only time that the company directly benefits from the sale of its stock (unless they issue more shares later). What we know as the stock market is actually a secondary market, where these shares of stock are traded (bought and sold) amongst investors. When a stock’s share price goes up, there is no affect on the actual financials of the company. They’ve already raised their money on the initial sale (IPO).

There are also multiple stock markets or exchanges. The New York Stock Exchange (NYSE) is probably the most well know, but there is also the NASDAQ or the American Stock Exchange (AMEX). These are simply markets where stock certificates are bought and sold. Don’t complicate this; it isn’t rocket science. How much a stock is then worth depends on how much someone is willing to pay and how much someone is willing to sell for. Supply and Demand.

Without getting into more detail yet, remember that when you’re purchasing stock, you’re buying an ownership interest in the company. You don’t really own stocks; you own pieces of companies. This is important to remember because the next step is figuring out which companies are worth owning (buying) and which companies are no longer worth owning (selling). I’ll talk more about this later, but for now, feel free to chime in on this.