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.
The best investors have a lot of experience and ability to spot the best moves on the market. Here are seven tricks for successful investment portfolio management.
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.
Making Conservative Valuations
First, be conservative In your valuation assumptions. Investors often have a 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 that you'll overpay for excellent businesses but, rather, you'll pay too much for mediocre businesses during generally prosperous times.
Err on the side of caution, especially when estimating future growth rates of a business to determine the potential return. For an investor with 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%. With an expected growth rate of 14%, however, the estimated intrinsic value per share is $114, or 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 purchase assets trading near (in the case of excellent businesses) or substantially below (in the case of other businesses) your estimate of intrinsic value. It's critical to 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 strong financials—paying a full price, and regularly buying additional shares through new purchases and reinvesting your dividends, can be rational.
But those types of businesses are rare. When dealing with these sorts of firms, it is wise to demand an additional margin of safety by tempering earnings through cyclical adjustments or only paying a price that approximates no more around 66% of your estimated intrinsic value, for example.
Building upon our prior example of a company with an estimated intrinsic value of $15.42, this means you wouldn’t want to purchase the stock if it was trading at $13.88 because 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 another Great 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 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 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 reasonably forecast where a business will be within five to 10 years, it's probably not wise to purchase the stock. Many investments fizzle out, even when you do understand the industry at hand. The key is to avoid seduction by excitement.
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 areas of investment available to you, but they're not critical to achieving your financial dreams. Many investors are unwilling to put some opportunities under the “too difficult” pile, though. 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 formidable investing career.
3. Measure Operating Performance, Not Stock Price
Unfortunately, many investors look to the current market price of an asset for validation and measurement, when 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, liquidating their stakes in hotels, restaurants, manufacturing plants, insurance companies, banks, and more, all because they had lost 60% or 70% 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.
Some investors have a penchant for gambling, treating stocks like 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% or 50% 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 providing a good return on equity.
4. 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 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. Had you controlled frictional expenses, keeping most of that 2% in your portfolio compounding for your family, you'd have ended up with over $12 million by retirement, nearly twice as much capital.
Although it seems counterintuitive, 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 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 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 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 own investment portfolio management. 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.
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 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 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 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 mortgages or credit card debt. Even though it might seem foolish on a first-glance basis, it's better 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. 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.