Investing in stock markets can seem daunting. Part I explained why it’s a mug’s game to try to compete against the professional finance industry with short term trading. And market prices swing around in longer cycles too, with big falls happening roughly every six years on average. But once you understand these things the good news is that there are ways to invest that significantly increase your chances of a highly profitable outcome.
The first steps to investment success involve really getting to grip with some basics. Too often these are glossed over and assumed to be well understood by everyone. Unfortunately, in my experience of talking to hundreds of private and professional investors over the years, the basics are frequently poorly understood or just ignored. This is a recipe for poor results.
A great starting point is to understand the difference between value and price. Far too much financial literature and commentary assumes that these are the same thing. Even a little thought shows that they are clearly different.
Something’s value is what it’s worth. This is a highly subjective concept. Different things are worth different amounts to different people, based on a wide range of factors and assumptions about what may happen in future.
There are a number of financial tools available that help to assess the value of stocks and shares. The simplest of these are things like the average historical price-to-earnings ratios (P/E) or price-to-book ratios (P/B).
There are also more advanced concepts such as the net present value (NPV) of projected future cash flows of a business. Calculating an NPV is a complex process that uses a lot of assumptions about likely earnings growth in future years, and how much return is required to make up for the risk of owning the asset being valued.
None of the available methods is perfect. And there are lots of other issues issues to look at as well, beyond financial number crunching. These are things like track record of company management, products, market share, competition, government policy and so on. But by using a range of methods a skilled analyst can come up with a range of values. Barring any major changes to the company, its value is a fairly stable quantity that usually grows over time (with price inflation, if nothing else).
As well as a value every potential investment also has a price. A price isn’t subjective at all. It’s what you can actually buy or sell something for in the markets at a moment in time. It’s observable and precise at that moment, although often fast changing from one moment to the next.
But what determines that price? Well, individual markets operate in different ways, so I’ll keep things general. But essentially it’s the clearing price at which some investors are prepared to give up ownership and new investors are prepared to take on ownership.
Put another way, most of the time most owners won’t be tempted to sell unless prices go higher, and most potential buyers will wait for lower prices before buying. But the current market price is where a few from both groups find counterparties willing to transact with them at a level that they find agreeable.
There’s an old joke in financial markets, probably springing from poor financial journalism.
Question: “Why did the market go up today?”
Answer: “There were more buyers than sellers.”
The joke, clearly, is that there is always the same volume of shares bought as shares sold. It takes two to tango, so to speak.
What really happens when market prices rise is that interested buyers are having to offer more money to tempt a few owners to sell. They have to raise their bids. And when prices fall, sellers are having to accept less money to tempt buyers to pay up. They have to reduce their offer prices.
We can use this knowledge to our advantage – about price versus value, and about the futility of short term trading in a professional market.
We need to define an investment strategy that will work for private investors in stock markets. The good news is that the principles are actually pretty straightforward. The hard part is having the emotional discipline to make it work.
Here at OfWealth we’ve talked a bit about the emotional side before. It’s what I call “learning to control your inner monkey”. There’s no magic to it. The first step is to understand the kind of emotions that investors are subject to, like fear and greed. Once you’ve done that you can start working on trying to control them. You use this by using your intelligent human brain to override your emotional monkey brain.
The next step is working out when to buy. If you think something is worth around $100 a share then you should try to buy it for less than $100. Preferably much less. This is just common sense.
The upside between the price you pay and the underlying value is what’s know as the “margin of safety”. So if you buy at $80 but the value is $100 then the margin of safety is 25% ($20 upside divided by $80 paid, as a percentage).
The margin of safety is there to help avoid mishaps. The bigger it is, the greater the likelihood that the share price will eventually rise. This is not to say that the price can’t fall in the short term, just because something is already cheap. It just means you’re already getting good value.
That said, you never know when or if the market price will rise to fair value, or above it. It’s just that something cheap is more likely to rise over a few years than something already expensive.
In my experience it usually takes between two and five years for prices of value investments to rise or exceed fair value. In other words there is usually no route to “get rich quick”. Most of the time you need to take your time.
Of course, sometimes things work out more quickly – over just a few months – and sometimes they take longer – with investments maturing over many years, like a fine wine. But by buying things when they are cheap, and applying this strategy consistently across a range of investments, you’ll usually get decent results within a few years. Buying cheaply is likely to result in healthy profits in the long run.
“Risk” is a two way street
I’m not saying that there is no luck involved at the individual investment level. Far from it. Sometimes there will be a turn of events that damages its value, however carefully you selected it in the first place. Perhaps a change of government policy, or an unforeseen new technology, or new competitors, or changing consumer habits, or a fraud. On the other hand you could also have unforeseen good luck, increasing the value of the investment, and hence further increasing the margin of safety. “Risk” is a two way street.
This random element of luck applies to all investments, whatever approach is taken. By going the value investing route – where purchase price is well below value – you’re using an approach that reduces that risk of bad luck. By having a fat margin of safety to the upside you are improving your overall odds of a good outcome. If you buy something worth $100 today at a price of $80 it has to lose 20% of its value before you’ve made a bad purchase.
Put it all together and you need to be calm and collected, take a long term approach, and buy bargains – when the market price of something is well below value estimates.
That’s it. The framework is really that simple. Of course putting it into practice is harder. Emotions can get the better of us. There are constant temptations to get involved in trading the latest hot ideas. And working out when something is cheap isn’t always easy.
But at least if you know what you should try to do you‘ll have a much better chance of facing the monster money machine and coming out on top. And that, of course, means making a healthy profit from your investments.
Stay tuned OfWealthers,