Important Principle in Investing Stock Market

The first principle essentially relates to the most often discusses ratio in the financial world, the price-to-earnings ratio, or simply the P/E ratio. The market P/E ratio rose from 18 in the early 1990s to about 30 in the early 2000s as interest rates declined steadily during the same period of time. As the interest rates increased starting in the early 2000s, the market P/E ratio declined back to below 20. During the mid 1970s to early 1980s, the market P/E ratio went down to as low as 7 to 9 because of high interest rates and economic slowdown.

There are two lessons that we can learn from history. First, it is generally a good idea to avoid investing in stocks when the market P/E ratio is high, say higher than 20. Second, we can extend the same argument to individual stocks, with one caveat. You should examine a company's P/E ratio over a number of years, by looking, perhaps, at the price in relation to the past five to ten years' earnings. If you use only recent earnings, a company may have a low P/E ratio because earnings are temporarily high, or it may have a high P/E ratio because earnings are temporarily low.

Several successful investors have used the P/E ratio as the core of their investment strategy, including John Neff, who was known for successfully managing billions of dollar through the Vanguard Windsor Fund for more than 30 years. Very few mutual fund managers have managed large portfolios successfully for such a long period. John Neff was so successful because he relied on relentless applications of low P/E sympathies, abetted by attention to fundamentals and a liberal dose of common sense.

Investors may also use other valuation ratios such as the market-to-book or the S&P 500 earnings as a fraction of gross domestic product (GDP). At the aggregate level, it does not matter which ratio you examine. The results are similar. At the individual stock level, whether you use the P/E ratio or the market-to-book ratio or another ratio entirely, you should depend on the nature of the company's business and the availability of suitable data.

This first important principle is known as value investing. The term value investing also commonly invoked when one does not invest in fast growing companies or sticks to conservatively financed companies. A value investor is someone who is focuses first and foremost on preserving capital. Earning high returns is desirable but secondary.