Keys to Successful Investing and Portfolio Management
Unlock the door to financial independence
At its core, investing is simple. That doesn't mean it is easy, just that the behaviors necessary for success are fairly straightforward. By reminding yourself of what they are, and always keeping them in the back of your mind, you can improve your odds of reaching financial independence as you amass a collection of assets that create passive income.
1. Insist Upon a Margin of Safety
Benjamin Graham, the father of modern security analysis, taught that building a margin of safety into your investments is the single most important thing you can do to protect your portfolio. There are two ways you can incorporate this principle into your investment selection process.
First, be conservative In your valuation assumptions. As a class, investors have a peculiar habit of extrapolating recent events into the future. When times are good, they become overly optimistic about the prospects of their enterprises. As Graham pointed out in his landmark investment book The Intelligent Investor, the chief risk is not overpaying for excellent businesses but rather paying too much for mediocre businesses during generally prosperous times.
To avoid this situation, err on the side of caution, especially in the area of estimating future growth rates when valuing a business to determine the potential return. For an investor with a 15 percent required rate of return, a business that generates $1 per share in profit is worth $14.29 if the business is expected to grow at 8 percent. With expected growth rate of 14 percent, however, the estimated intrinsic value per share is $100, or seven times as much.
Second, only purchase assets trading near (in the case of excellent businesses) or substantially below (in the case of other businesses) your estimate of intrinsic value. Once you’ve conservatively estimated the intrinsic value of a stock or private business, such as a car wash held through a limited liability company, make sure you are getting a fair deal. How much you are willing to pay depends on a variety of factors, but that price will determine your rate of return.
In the case of an exceptional enterprise—the type of company with huge competitive advantages, economies of scale, brand name protection, mouthwatering returns on capital, and a strong balance sheet, income statement, and cash flow statement—paying a full price, and regularly buying additional shares through new purchases and reinvesting your dividends, can be rational.
Those types of businesses are rare. Most fall into the territory or secondary or tertiary quality. When dealing with these sorts of firms, it is wise to demand an additional margin of safety by tempering earnings through cyclical adjustments and/or only paying a price that approximates no more than 66 percent or your estimated intrinsic value, which you will get from time to time. It's the nature of the stock market. In fact, historically, drops in quoted market value of 33 percent or more are fairly common every few years.
Building upon our prior example of a company with an estimated intrinsic value of $14.29, this means you wouldn’t want to purchase the stock if it was trading at $12.86 because that is only a 10 percent margin of safety. Instead, you’d want to wait for it to fall to around $9.57. It would allow you to have additional downside protection in the event of another Great Depression or 1973–1974 collapse.
2. Invest In Assets You Understand
How can you estimate the future earnings per share of a company? In the case of a major beverage company, for example, you could look at per-capita product consumption by various countries in the world, input costs such as sugar prices, management’s history for allocating capital, and a whole list of things. You'd build spreadsheets, run scenarios, and come up with a range of future projections based on different confidence levels. All of this requires understanding how the businesses make their money.
Shockingly, many investors ignore this common sense and invest in companies that operate outside of their knowledge base. Unless you understand the economics of an industry and can forecast where a business will be within five to ten years with reasonable certainty, do not purchase the stock. In most cases, your actions are driven by a fear of being left out of a “sure thing” or forgoing the potential of a huge payoff. If that describes you, you’ll take comfort to know that following the invention of the car, television, computer, and Internet, there were thousands of companies that came into existence, only to go bust in the end. From a societal standpoint, these technological advances were major accomplishments. As investments, a vast majority fizzled. The key is to avoid seduction by excitement. The money spends the same, regardless of whether you are selling hot dogs or microchips. Forget this, and you can lose everything.
To be a successful investor, you don’t have to understand convertible arbitrage, esoteric fixed-income trading strategies, stock option valuation, or even advanced accounting. These things expand the potential area of investment available to you—valuable, yet not critical to achieving your financial dreams. Many investors are unwilling to put some opportunities under the “too difficult” pile, though, reluctant to admit they are not up to the task. Even billionaire Warren Buffett, renowned for his vast knowledge of business, finance, accounting, tax law, and management, admits his shortcomings.
At the 2003 Berkshire Hathaway stockholder meeting, Buffett, responding to a question about the telecom industry, said:
“I know people will be drinking Coke, using Gillette blades and eating Snickers bars in 10 to 20 years, and have a rough idea of how much profit they’ll be making. But I don’t know anything about telecom. It doesn’t bother me. Somebody will make money on cocoa beans, but not me. I don’t worry about what I don’t know—I worry about being sure about what I do know.”
This ability to examine his strengths and weaknesses is one way Buffett has managed to avoid making major mistakes over his considerable investing career.
3. Measure Your Success by the Underlying Operating Performance of the Business, Not the Stock Price
Unfortunately, many investors look to the current market price of an asset for validation and measurement, when in the long run it follows the underlying performance of the cash generated by the asset. The lesson? Underlying performance is what counts.
One historical example: During the 1970s market crash, people sold fantastic long-term holdings that had fallen to 2x or 3x earnings, liquidating their stakes in hotels, restaurants, manufacturing plants, insurance companies, banks, candy makers, flour mills, pharmaceutical giants, and railroads all because they had lost 60 percent or 70 percent on paper. The underlying enterprises were fine, in many cases pumping out as much money as ever. Those with the discipline and foresight to sit at home and collect their dividends went on to compound their money at jaw-dropping rates over the subsequent 40 years despite inflation and deflation, war and peace, incredible technological changes, and several stock market bubbles and bursts.
That fundamentals matter seems to be an impossible truth for a certain minority of investors with a penchant for gambling, to whom stocks are essentially magical lottery tickets. These types of speculators come and go, getting wiped out after nearly every collapse. The disciplined investor can avoid that cycle by acquiring assets that generate ever-growing sums of cash, holding them in the most tax-efficient way available, and letting time do the rest. Whether you're up 30 percent or 50 percent in any given year doesn't matter much as long as the profits and dividends keep growing skyward at a rate substantially in excess of inflation and that represents a good return on equity.
4. Be Rational About Price
The higher a price you pay for an asset in relation to its earnings, the lower your return assuming a constant valuation multiple. The same stock that was a terrible investment at $40 per share may be a wonderful investment at $20. In the hustle and bustle of Wall Street, many people forget this basic premise and, sadly, pay for it with their pocketbooks.
Imagine you purchased a new home in an excellent neighborhood for $500,000. A week later, someone knocks on your door and offers you $300,000 for the house. You would laugh in their face. In the stock market, you may be likely to panic and sell your proportional interest in the business simply because other people think it is worth less than you paid for it.
If you’ve done your homework, provided an ample margin of safety, and are hopeful about the long-term economics of the business, you should view price declines as an opportunity to acquire more of a good thing. Instead, people tend to get excited about stocks that rapidly increase in price, a completely irrational position for those who were hoping to build a large position in the business. Would you want to buy more gas if per-gallon prices doubled? Why then should you view equity in a company differently? Investors who behave that way are more gambling than investing.
5. Minimize Costs, Expenses, and Fees
Frequent trading can substantially lower your long-term results due to commissions, fees, ask/bid spreads, and taxes. Combined with understanding the time value of money, the results can be staggering when you start talking about 10-, 15-, 25-, and 50-year stretches.
Imagine that in the 1960s, you are 21 years old. You plan to retire on your 65th birthday, giving you 44 financially productive years. Each year, you invest $10,000 for your future in small capitalization stocks. Over that time, you would have earned a 12 percent rate of return. If you spent 2 percent on costs, you would end up with $6,526,408. It's certainly not chump change by anyone’s standards. Had you controlled frictional expenses, keeping most of that 2 percent in your portfolio compounding for your family, you'd have ended up with $12,118,125 by retirement, nearly twice as much capital. Although it seems counterintuitive, frequent activity is often the enemy of long-term superior results.
6. Keep Your Eyes Open for Opportunities
Like all great investors, famed mutual fund manager Peter Lynch was always on the lookout for the next opportunity. During his tenure at Fidelity, he made no secret of his investigative homework: traveling the country, examining companies, testing products, visiting management, and quizzing his family about their shopping trips. It led him to discover some of the greatest growth stories of his day long before Wall Street became aware they existed.
The same holds true for your portfolio. By simply keeping your eyes open, you can stumble onto a profitable enterprise far easier than you can by scanning the pages of financial publications.
7. Allocate Capital By Opportunity Cost
Should you pay off your debt or invest? Buy government bonds or common stock? Go with a fixed rate or interest-only mortgage? The answer to financial questions such as these should always be made based on your expected opportunity cost.
Opportunity cost investing means looking at every potential use of cash and comparing it to the one that offers you the highest risk-adjusted return. It's about evaluating alternatives. Here's an example: Imagine your family owns a chain of successful craft stores. You are growing sales and profits at 30 percent as you expand across the country. It wouldn't make a lot of sense to buy real estate properties with 4 percent cap rates in San Francisco for the sake of diversifying your passive income. You'll end up far poorer than you otherwise would have been. Rather, you should consider opening another location, adding additional cash flow to your family treasury from doing what you know how to do best.
In the context of opportunity cost investing, the concept of risk-adjusted returns is extremely important. You cannot just look at the sticker rate and come to a conclusion; you have to figure out the potential downsides, probabilities, and other relevant factors. Picture yourself as a successful doctor. You and your wife have $150,000 in student loan debt at 5 percent interest. In this case, it doesn't matter if you can earn 10 percent by investing that money; it might be wiser to pay off the liabilities.
Why? The bankruptcy code in the United States treats student loan debt as an especially poisonous type of liability. It can be nearly impossible to discharge. If you fall behind on your bills, the late fees and interest rates can spiral out of control, depending upon the type of student loan. You can have your Social Security checks garnished during retirement. It's far more vicious, in many cases, than things like mortgages or credit card debt. Even though it might seem foolish on a first-glance basis, it is the wiser course of action to eliminate the potential landmine during moments of prosperity.
Even if you regularly buy index funds through a dollar cost averaging, opportunity cost matters to you. Unless you are more prosperous than the median family, you probably won't have enough disposable income to maximize all of your retirement contribution limits. It means you have to look at your available options and prioritize where your money goes first to make sure you get the most bang for your buck.
Opportunity Cost: Example
Let's say you work for a company with 100 percent matching on the first 3 percent of income through their 401(k) plan. Your salary is $50,000 per year. Assuming you are debt-free, in this case, many financial planners may tell you to:
- Fund the 401(k) up to the 3 percent matching threshold to get the most free money you can. In this case, $1,500. You'd get $1,500 in matched funds, providing an instant risk-free doubling of your money.
- Fund a Roth IRA up to the maximum allowed contribution limit for both you and your spouse. They are better than Traditional IRAs in many cases.
- Build a six-month emergency fund in a highly liquid, FDIC-insured savings account that you don't use otherwise.
- Go back and fund your 401(k) up to the remaining contribution limit. Even though you won't get any more matching money, you'll be able to take a fairly large tax deduction, and the money will grow tax-free within the account until you retire or take it out of the protective confines of the tax shelter.
- Buy index funds, blue chip stocks, bonds, or other assets through taxable brokerage accounts and/or acquire real estate for the rental income depending upon your preferences, skills, risk profile, and resources.
By adhering to a plan like this, you make sure the money gets allocated to the most advantageous uses first, providing the most utility for you and your family if you run out of cash to save before reaching the bottom of the list.