by James Brumley

Created on: May 18, 2008   Last Updated: September 11, 2008

With dozens of television stations, newspapers, and magazines dedicated to the industry, it can be easy for a new investor to be intimidated. Fortunately, everybody has the ability to be a successful investor, regardless of experience, by keeping one cardinal rule in mind - common sense prevails.

Assuming your account is already established and you're familiar with the basic mechanics of placing a trade, the philosophy of 'common sense' is turned into reality with three simple concepts.

1. Defense is more important than offense.

Frequently, new investors will be told to "Never invest money you're really not willing to lose". The intent is honorable, though the advice itself may be incomplete. A healthier way of getting the right message across may be to say "Never put yourself in a situation where losing everything is a possibility".

While there are never guarantees of good performance, there are ways to defend against the effect of poorly-performing stocks. They are diversification, stop losses, and owning stocks of quality companies.

Diversification is the practice of owning a handful of companies rather than just one. One stock is the equivalent to putting all your eggs in one basket.

A stop loss is a type of order entered with your brokerage firm that instructs them to sell a stock if-and-when it falls below a certain price. Selling it may lock in a loss, but a small loss is better than a big loss you didn't know about until it was too late.

And what about quality stocks? No stock is immune to losses, but stocks of companies that are profitable and proven are much less likely to lose ground.

2. Eventually, a company has to justify its stock price.

It's fun to speculate on the next big biotech breakthrough. Unfortunately, it's rarely profitable. If the company does not win the FDA's approval, or if another company beats a pharmaceutical company to the market with a comparable drug, the stock's only attraction can be wiped way in the blink of an eye.

Though the biotech example of investment risk is well understood by most, the underlying idea should apply to all stocks - a company can't support its stock price on potential alone...at least not forever.

Of course, applying this premise requires homework. Investors should familiarize themselves with the concept of stock valuations. Price/earnings ratios, price/sales ratios, revenue growth, and earnings growth are relatively easy tools you can use to compare one stock to another when determining whether or not a company's stock price (now or projected) makes sense.

3. Patience pays off.

Yes, some stocks make miraculous gains in short periods of time. Most do not though. While it's tempting to liquidate a stagnant position, or a position with a recently-made profit, most investors are better served by holding onto quality stocks...even if it gets boring.

Complicated concepts? Not at all. Some would even say they're surprisingly simple. However, the true measure of their worth is measured in your bottom line. Many veteran investors have battle scars as a result of forgetting basic rules like these.

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