At its core, investing is simple. That doesn't mean it is easy. It just means that what you need for success is fairly straightforward. Be sure to keep this in the back of your mind; it can help you improve your odds of reaching financial independence as you amass assets that create passive income.
The best investors have the ability to spot the best moves on the market. Here are seven tricks for successful investing.
- Investing is simple, but it's not easy. There are seven tricks you can use for successful investing.
- First, insist upon a margin of safety, and it's best to invest in assets you understand.
- Measure operating performance rather than the stock price, minimize costs, and be rational about price.
- Always keep your eyes open for opportunities, and allocate capital by opportunity cost.
1. Insist Upon a Margin of Safety
Benjamin Graham was the father of modern security analysis. He 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.
Make Conservative Valuations
First, be conservative In your valuation assumptions. Many have a habit of extrapolating recent events into the future. When times are good, they may become too optimistic about their prospects. As Graham pointed out in his book, "The Intelligent Investor," the chief risk is not that you'll overpay for excellent firms. The risk is that you'll pay too much for mediocre businesses during prosperous times.
Err on the side of caution. This is even more true when it comes to estimating the future growth rates of a business to find the potential return. If you have a 15% required rate of return, a business that generates $1 per share in profit is worth $15.42 if the business is expected to grow at 8%.
But with an expected growth rate of 14%, the estimated value per share is $114; this is seven times as much. Dig into the numbers a company is giving you for its expected growth rate before you pay that much.
Second, only buy assets trading near your estimate of intrinsic value in the case of excellent businesses. On the other hand, only buy those trading substantially below in the case of other firms. It's crucial to make sure you are getting a fair deal. How much you are willing to pay depends on a variety of factors; that price will determine your rate of return.
In the case of an exceptional enterprise, paying a full price and regularly buying more shares can be a good idea.
These types of businesses may have huge advantages, economies of scale, brand name protection, attractive returns on capital, and strong financials.
But those types of businesses are rare. When dealing with these sorts of firms, it is wise to demand an extra margin of safety. You may want to temper earnings through cyclical adjustments; or, you may want to only pay a price that approximates no more than about 66% of your estimated intrinsic value, for instance.
Let's build upon our prior example of a firm with an estimated value of $15.42. This means you wouldn’t want to buy the stock if it was trading at $13.88; that is only a 10% margin of safety. $10.18 (66%) would be a safe price because it would allow you to have additional downside protection in the event of a depression.
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 instance, there are a few things 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 other 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 knowing how businesses make their money.
But many ignore this common sense. They may invest in firms 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 10 years, it may not be wise to purchase the stock. Many investments fizzle out. This is true even when you do understand the industry at hand. The key is to avoid getting too excited.
To be successful, you don’t have to understand convertible arbitrage, esoteric fixed-income trading strategies, stock option valuation, or even advanced accounting. These things expand what's available to you, but they're not critical to achieving your goals. Many people are unwilling to put some opportunities under the “too difficult” pile, though. Even billionaire Warren Buffett, who has a vast knowledge in a variety of business areas, admits his shortcomings.
At the 2003 Berkshire Hathaway stockholder meeting, Buffett responded to a question about the telecom industry. He 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 career.
3. Measure Operating Performance, Not Stock Price
Many investors look to the current market price of an asset for validation and measurement. In the long run, that price simply follows the underlying performance of the cash generated by the asset.
During the 1970s market crash, people sold fantastic long-term holdings that had dropped significantly. They liquidated their stakes in hotels, restaurants, manufacturing plants, insurance companies, banks, and more; this was all because they had lost 60% or 70% on paper. The underlying enterprises were fine. In many cases, they were 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. This happened despite inflation and deflation, war and peace, incredible technological changes, and several stock market bubbles and bursts.
Some investors have a penchant for gambling; they may treat stocks like magical lottery tickets. These types of speculators come and go, getting wiped out after nearly every collapse. If you're disciplined, you can avoid that cycle by acquiring assets that generate ever-growing sums of cash. You can hold them in the most tax-efficient way available, and let time do the rest.
Whether you're up 30% or 50% in any given year doesn't matter much. It's more important that profits and dividends keep growing at a rate substantially in excess of inflation and providing a good return on equity.
4. Minimize Costs, Expenses, and Fees
Frequent trading can substantially lower your long-term results; this is 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 you are 21 years old in the 1960s. 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% rate of return. If you spent 2% on costs, you would end up with $6.5 million. It's certainly not chump change by anyone’s standards. But what if you had controlled frictional expenses, keeping most of that 2% in your portfolio compounding for your family? In that case, you would have ended up with over $12 million by retirement, nearly twice as much capital.
It may seem counterintuitive. But frequent activity is often the enemy of long-term superior results.
5. Be Rational About Price
The same stock that was a terrible investment at $40 per share may be a great decision at $20. In the hustle and bustle of Wall Street, many people forget this basic premise; sadly, they pay for it with their pocketbooks.
Let's say you bought 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 might 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, don't panic. You should view price declines as an opportunity to acquire more of a good thing. But instead, people tend to get excited about stocks that quickly increase in price. This is an irrational move 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? Those who behave that way are gambling, not investing.
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 homework: traveling the U.S., taking a close look into companies, testing products, talking to management, and quizzing his family about their shopping trips. It led him to find some of the greatest growth stories of his day; all of this was long before Wall Street became aware these firms existed.
The same holds true for your own portfolio management. Simply keep your eyes open. You may stumble into something good far easier than you could 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 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.
Imagine your family owns a chain of successful craft stores. You are growing sales and profits at 30% as you expand across the country. It wouldn't make a lot of sense to buy real estate properties with 4% 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 think about opening another location. This adds more cash flow to your family treasury from doing what you know how to do best.
When it comes to opportunity-cost investing, the concept of risk-adjusted returns is crucial. You cannot just look at the sticker rate and come to a conclusion; you have to figure out the potential downsides, probabilities, and other factors. Let's say you're a doctor with $150,000 in student loan debt at 5% interest. In this case, it doesn't matter if you can earn 10% by investing that money; it might be wiser to pay off the liabilities.
Why? The bankruptcy code in the U.S. 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; it depends 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 mortgages or credit card debt. Even though it might seem foolish on a first-glance basis, it's better to get rid of 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 many, you probably won't have enough disposable income to maximize all of your retirement contribution limits. You have to look at your available option. Then, prioritize where your money goes first. This can help make sure you get the most bang for your buck.