Bill O'Neil, founder of Investor's Business Daily, is one of the most important thinkers to come out of investing in the last 30 years. His CAN SLIM™ methodology for evaluating stocks was one of the most enduring systems for making money in the stock market. O'Neil bought a seat on the New York Stock Exchange at age 30 (makes us wonder what we've been doing with our time!) and his investment research company William O'Neil & Co.Inc. counts among its clients hundreds of the top institutional investment firms worldwide.

The Motley Fool's Senior Editor for Investing Bill Mann (TMF Otter) recently spent some time with O'Neil ahead of the release of the third edition of his national bestseller How to Make Money in Stocks. Today we offer the first part of our interview, to be concluded next week.

TMF Otter: Many people have learned for the first time what a real bear market feels like. The last prolonged pain in the stock market came more than two decades ago, when far fewer people were active in the stock market. What are some of your key observations on investing today?

O'Neil:  The stock market is human nature on parade. Intelligent, highly educated human beings can easily get into trouble and lose money because the stock market nearly always moves directly opposite to the psychology of the typical investor. For example: We are a nation of bargain seekers. We want to buy something that seems cheap because it's on sale. So, people buy a stock on the way down at 50 because it was 80 and looks like a real deal. This is a deadly sin in the market and one of the worst habits an investor can have. Why try to catch a falling dagger? Stocks that decline more than normal are under heavy liquidation by institutional investors and are almost always down for a reason -- i.e., the tide has turned for the company and something is starting to go wrong.

TMF Otter: It's funny, because it seems that there is no middle ground for the typical investor. He can either get excited about some company because the stock is going up, he can be terrified because it is dropping, or he can get greedy because it looks like a bargain since it has dropped so much. How do you suggest investors learn to improve their success rate in stock selection?

O'Neil:  Anyone can learn to invest more intelligently and much more profitably, but you must begin by reading and studying the few right books on the market and becoming brutally realistic about all common stocks. First, you must recognize that you are simply not going to be right all of the time. Big league baseball players are outstanding if they hit three times out of ten. Three-point basketball shooters are good if they score on four of ten shots. An all-pro passer in football may be great if he hits six and misses four. In a lifetime of investing, you'll probably only be right five or six times out of ten. So you absolutely must have a rule to always protect yourself. When you start off wrong, you are exposing yourself to a loss that can at least half of the time get larger and larger until it does serious damage to your portfolio. 

TMF Otter: You've stated publicly that an investor who followed your system would have avoided the egregious losses suffered by holders of Enron or Global Crossing. How would an investor be protected in your mind without also taking the chance of selling out on good companies way too soon?

O'Neil: My rule is simple -- any stock that I buy that declines 7% or 8% below my actual purchase price, I will always without exception, sell to cut short my loss.

TMF Otter: No exceptions?

O'Neil: None. This way I guarantee myself that my capital will never be exposed to a 25%, 50%, or 75%, loss which is always difficult to recover from. So, your first loss is always your smallest loss. The only insurance policy you can take out to protect against a large devastating loss is to cut them all without exception while they're still small. 

TMF Otter: No averaging down? No buying back a stock that you are convinced is undervalued?

O'Neil: I will never average down in price. If I bought at $50, I will never buy more at $45 or $40 -- that's risking more money in a stock that's already wrong and not working -- so why put more good money after bad?

I prefer to average up on each stock that is working. At least, when you're right and the stock proves it by going up in price, you'll have more money in the one you're right on and less in the stock where you're wrong. So, you see, the real key to stock market success is not to be right all the time (which you can't be) but to have more of your money in the stocks you're right on and lose less percentage wise and have fewer dollars in the stocks where you're wrong. A few really big profits and several smaller losses is your objective.

TMF Otter: With over 10,000 stocks to choose from, how many stocks should you own?

O'Neil: Before you begin to invest, decide how many stocks you will own. 

TMF Otter: Easier said than done, right? Every investment guru alive tells us that we need to be diversified. Plus, it's easy to get excited about the next "new opportunity."

O'Neil: If you have $15,000 to invest, limit yourself to three stocks bought one at a time. Don't buy them all at once. If you have $50,000, limit yourself to four stocks; $100,000, five stocks; and if $1 million, six or seven. You don't need to over-diversify or over asset allocate. Money is made by putting your eggs slowly and intelligently into fewer baskets you know well and watching those very carefully. Over-diversification is a hedge for ignorance.

TMF Otter: That's a fairly contrary opinion. How do you ensure that the companies you hold are good ones? It seems like your margin for error is much smaller.

O'Neil:  For more than 40 years of investing, I never bought stocks based on tips, thoughts, rumors from friends, brokerage firms, or analyst reports, technical analyst recommendations, or assumed experts pushing their favorite picks on market TV programs. That's a fast way to lose money. 

TMF Otter: Obviously, then the key for you is stock selection. But in How to Make Money in Stocks you are very clear about the need both for a defined buying strategy and a defined sell strategy. What are your definitions based upon?

O'Neil: Rather than listening to Wall Street's conventional wisdom and strong egos, we analyzed all of the best-performing stocks each year for the past 50 years. We evaluated all the known fundamental and technical variables each super winner showed before they soared 100% to 1000% or more. Plus, we studied how these variables changed when these great winners finally topped and began their substantial price declines. 

Our buy and sell rules were not based on our personal beliefs, systems, philosophy or opinions, but precisely on how the stock market actually worked for the last half century.

TMF Otter: What you're talking about are home runs. Most investors would suggest that the current market is one that favors singles, or maybe even errors and strikeouts.

O'Neil: That's the key point of the "M" in our CAN SLIM™ methodology. You have to respect what the market is telling you.... If it's down, we don't try to fight against that trend by buying stocks. I wait until you see a confirmed uptrend and know it's safe to buy.

Read Part 2 of this interview.

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