Five Rules To Consider Before Taking the Plunge Into Stocks

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When we think about investing, most people think stocks. But the truth of the matter is, the majority of investors aren't trading stocks on a day to day basis. They've put their money in the hands of mutual funds: baskets of investments with managers who do the bulk of the work for them. It's one of the most efficient ways to invest because you automatically have your hand in hundreds of different investments. When one bottoms out, the logic goes, the others are there to pick up the slack.But maybe you want to dabble in stocks. You're interested in the inner-workings of individual companies, and you want to get more hands on. That's okay, too. Superstar investors like Peter Lynch and Warren Buffett made their names -- and fortunes -- by being smart pickers of individual stocks. It's important, though, that you follow a few rules:

1. Learn Before You Leap. Individual stocks, when they're not moving strictly with market forces, rise and fall with the fortunes of their companies. If you're going to play in this pool, you need to understand what pieces of data are likely to cause a move: things like earnings, debt, new product announcements, mergers and acquisitions, and the management team. The good news is that this information is available from legitimate sources over the Internet. These sources include discount brokers like Schwab (SCHW) and Fidelity (FNF), Morningstar (MORN), Investopedia, BloggingStocks. If it sounds like there's a lot to read, there is. The world of stock-picking is more than a little confusing, even for the experts, so you really need to have the time and dedication to do some due diligence before you jump in.

2. Limit Yourself. You don't want to play with your whole portfolio -- as I mentioned, the bulk of your money should be allocated between bonds, cash and stocks that you purchase through investment buckets like mutual funds. That's the only way for many individual investors to get themselves the diversification they need (something tough to do unless you own at least a dozen individual stocks.)

"Assuming that doesn't satisfy you, or quiet your urge to speculate, then you can pick stocks yourself, but make sure that you limit it to a small percentage of your total assets," suggests Hugh Johnson, chairman and chief investment officer of Johnson Illington Advisors in Albany, New York. My advice? Keep your stock picking to 5% of your money -- 10% at the very most.

3. Diversify. Particularly if you've decided to allocate more than the aforementioned 5% or 10% of your investments to individual stocks, diversification becomes key. It may take a bit of the fun out of it -- a lot of people like to invest where their interests lie (or as Lynch said, "buy what you know"), so they'd be inclined to take all of their play money and throw it into, say, tech stocks. But there's no fun in losing money. Spread your cash around so you hit all sectors of the stock market: a little in consumer goods, a bit in healthcare, some financial, you get the idea.

4. Be Realistic. Repeat after me: The trend is your friend. "If a stock is rising, relative to the market, it's rising for a reason. If it's declining, relative to the market, it's declining for a reason. You're not as smart as the stock market, so never ignore the performance of stocks," says Johnson. Does that mean you should sell at the slightest fall? No -- and, in fact, that question brings me to my final point.

5. Set Rules -- And Then Follow Them. Emotion has no place in the stock market, and one way to quiet your freak-out reflex is by setting strict guidelines in advance. "You should have a sell discipline," explains Johnson. "So, for example, if a stock is down 20% relative to the rest of the market, then you may want to cut your losses. Being a good buyer is easier than being a good seller, but learning to have a sell discipline is crucial to success." You can set your limit based on your comfort level, but once you've settled on a rule, don't break it.
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