The 4 Best Words of Investing Advice

There is some great investing advice out there, and, of course, there's some pretty bad advice, too. In the latter category, you might have something like this: "It just doesn't matter how high the price is -- buy all the Enron you can."

And while you can spend all day listing smart and useful investment advice, I got to thinking about great advice that's limited to four-word chunks.

Let's check the results, shall we? First up:

"Buy what you know"
This is probably the second-most-famous four-word piece of investing advice that's come along. This one comes from, or is at least most popularly attributed to, Peter Lynch's One Up on Wall Street. In a timeless article written several years ago, Jeff Fischer writes at great length about this phrase:

[I]t is most often read to mean buy the brands that you know, buy the companies that make products that you like, and buy the company names that you always hear in daily life.

When large-cap stocks are soaring, this strategy, simple as it is, appears brilliant. "If I just buy General Electric and Hershey, I could double my money every three years!" Of course, when large caps go into long periods of rest or retraction, the strategy requires patience and offers less than blistering returns, especially if you "bought what you knew" as it was hitting a seven-year peak.

"Buy what you know" is one-dimensional advice for three reasons. First, what you know may not be worth investing in. Second, the practice of buying what you know is rarely interpreted to mean buy the business model, the cash flow statement, and the balance sheet that you know backwards and forward. It too often is seen as "buy your favorite brand." Period. If you happen to know and love Kmart, but you didn't learn about its financials, you [were] in a sorry situation because you were an uninformed investor. Third, I've never heard the term "buy what you know" coupled with anything regarding valuation. It seems to be "buy what you know -- at any price."

Thank you, Jeff. "Buy what you know" may help new investors get comfortable with the process, but it simply won't help you pick particularly good stocks if you don't get into the valuation side of the equation. Plenty of people have bought American Airlines parent AMR (NYSE: AMR  ) over the years because they "knew it," and that investment has largely been disastrous. In the late '90s, plenty bought Home Depot (NYSE: HD  ) because they "knew it." However, because of the valuation back then, they haven't been well rewarded, despite the growth of the company's business in the interim. Plenty of other people have recently bought Chipotle Mexican Grill (NYSE: CMG  ) (NYSE: CMG-B  )  because they knew it, and that's worked out very well -- so far. Simply put, acting on "buy what you know" doesn't lead you down any path in particular.

"Buy low, sell high"
I'm pretty sure this is the most famous four-word piece of investing advice ever, and as guidance, the phrase is unarguable. Yet it's also largely useless. By definition, if you succeed in buying low and selling high, you've made a profit. Any purchase is made with the expectation -- or at least hope -- that in absolute-dollar terms, you're going to be selling at a higher price than what you've bought for. But since the advice itself gives no guidance as to what is "low" and what is "high," it can't be used without a whole lot of addendums. Buy stocks with low P/Es, or at 52-week lows, or during bear markets, or any number of other interpretations of "buying low." Selling high might or might not be useful advice. After all, as Philip Fisher has famously written and as adopted by Warren Buffett, the best time to sell a stock, if it's properly researched, may be almost never.

We can all tell plenty of stories about someone selling a stock at a quick profit that seemed high but turned out to be several hundred or thousand percent below what they could have made by holding onto the stock. Tom Gardner frequently mentions Whole Foods Market and Websense when confessing to his own bad calls. Not to pick on Tom -- his results speak for themselves. But these were mistakes that came out of the "buy low, sell high" mold.

"Buy an index fund"
This is the most actionable, most mathematically supported short-form investment advice ever. If you look up The Motley Fool in the encyclopedia -- or at least on Wikipedia -- you'll find that we are "famous for [our] view that, for the majority of people who have little time to keep track of stocks, the best investment strategy can be summed up in four words: 'Buy an index fund.'"

And that remains true. If you've got little time to keep track of stocks, this really is the best investment advice around. It's not perfect -- after all, you might be asking, "Which index fund?" And then you'd want to specify certain characteristics, such as:

  • No load.
  • Low annual cost.
  • Low turnover.
  • Broad index.

That means a fund such as Vanguard Total Stock Market Index (VTSMX), which, coincidentally, may hold a lot of what you know, including GE, Wal-Mart (NYSE: WMT  ) , Citigroup (NYSE: C  ) , and Johnson & Johnson (NYSE: JNJ  ) .

When I'm cornered at cocktail parties for investment advice, this is the one piece I usually provide. After all, barely 25% of mutual funds over time beat the relevant market index. I don't think you can really improve on this advice if you're stuck using four words or fewer.

But you can spend more than four words on investment advice, and as with the other four-word mantras above, if you do so, you usually get even better advice. Like the classic index fund, a managed fund can be no-load, low-cost, low-turnover, and well-diversified. It can, on rare occasion, be managed by someone or some team that has the ability to properly allocate capital and value businesses and thereby add value over and above what the market average provides on its own. When you combine all of these factors, you get the potential to find a mutual fund that improves on the index fund and becomes something that will help you make money.

And they are out there. They take a bit of work to find (more than can be summed up in four words), but Motley Fool Champion Funds uncovers market-beating funds. So far, about 80% of the mutual funds that Fool fund advisor Shannon Zimmerman has recommended are beating their benchmarks, earning 34% returns, compared with 20% for their yardsticks over the same time period.

You can do just fine by sticking to an index fund, but you can do even better with a managed fund that adheres to the same principles that make the index fund so hard to beat -- but that also has exceptional management. Click here to learn more.

This article was originally published on Jan. 13, 2006. It has been updated.

Bill Barker owns shares of Home Depot but of no other company mentioned in this article. Home Depot and Wal-Mart are Motley Fool Inside Value recommendations. Johnson & Johnson is a Motley Fool Income Investor recommendation. Whole Foods is a current Stock Advisor pick. Chipotle is a Motley Fool Hidden Gems and Rule Breakers recommendation. The Motley Fool has a disclosure policy.


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