Saturday, June 22, 2013

Investing Series Part 1: What is Investing?

To understand successful investing , let's take two quotes from two well-known investors:

"An investment is an operation where upon thoroughly analysis, promises safety of principal and an adequate return" Benjamin Graham

"Investing is simple, but it is not easy" Warren Buffett

Benjamin Graham, the mentor to Warren Buffett, defined an investment as an operation that requires sufficient research to minimize the loss of principal and maximize potential gains. Buffett adds that an investment operation should be simple but not easy. The question now is, how to invest successfully? First, let's first compare investment to speculation to make sure everyone avoids the latter.

Investment vs. Speculation:

Under Graham's investment definition, anyone who takes an outright guess on the future direction of a security price is really speculating. An example is when traders take bets on the direction (long or short) of a stock, bond, currency or commodity. You are not forbid to speculate in anyway and in fact many market participants love the thrill of trying to make short term gains. However, the speculation game is really a zero-sum game because you're hoping that a sucker will be willing to pay a higher price than you paid. Some can profit enormously by speculating but it is not a game average investors should play, especially when you don't have a large time commitment. 

An investment operation differs because you actually analyze the underlying business, not the price trends. A stock is an ownership of business, not a ticker symbol with a price that fluctuates from 9:30am-4:00pm. As famous investor Phil Fischer said: "the stock market is filled with individuals who know the price of everything but the value of nothing". 

What is Value?

Value, more commonly known as "intrinsic value", is determined by the underlying asset's returns. In case of a stock, the value is derived from the underlying business operations and owners (shareholders) should expect returns similar to the profitability of the business. Peter Lynch claimed that in the long run, investors should expect average returns similar to the average earnings (profit) growth of the company despite large swings in the share price. A similar analysis can be used to estimate intrinsic value using a discounted cash flow approach; Buffett said that the value of a business is really just the sum of the discounted cash flows you can get out of the business throughout its life. By analyzing either the earnings power of the company and its future cash flows, investors can have a rough estimate of the actual intrinsic value. Nonetheless, Buffett admits himself that the calculation of intrinsic value is vague and sometimes it's better to think in ranges (or in range of multiples such as 10-12 times earnings) rather than a specific number. I.e. I might calculate the intrinsic value of stock X at $25-$35 and if the stock is trading at $15, I'll buy it. However, if the range is close, i.e. stock Y is trading at $25 while your calculated range is $25-$35, then the investment is not very attractive. Don't worry if the stock price keeps dropping after you buy it. As Graham reminds everyone: "you are neither right nor wrong because the crowd disagree with you, you are right because your data and reasoning are right". Investors are better off analyzing the facts and ignore short term fluctuation because the chances of predicting short term market movements are no better than a simple toss of a coin.

I'll wrap this section up with a Graham quote that nails the point of making successful investment: "investment is most intelligent when it is business-like". Buy the stock as if you were going to buy the underlying business.  

Common Mistake to Avoid:

One common mistake is that investors tend to "buy high and sell low". This sounds pretty counter-intuitive since most investors want to "buy low and sell high." The reality in the real-world is that investors are driven more by their emotions, not by their analysis. As stock prices soar higher and higher, many want to jump in (buy). As a result, many investors buy near the top of a bull market. As the market starts to decline, investors often hold onto their positions tenaciously in hope of breaking even until they finally give up (especially if they see losses over 50%) and sell everything. When everyone sells out, it's usually the end of a bear market. To avoid this mistake, follow Buffett's simple advice: "Be fearful when others are greedy, be greedy when others are fearful".  Buy when there is blood on the street and sell when everyone crowds in the stock market. Be extra cautious if everyone is more worried about missing opportunities than losing money.

Another common mistake is not selling the obvious losers. Investors don't like admitting mistakes so they tend to hold onto losers until they break-even. However, losers tend to decline further and investors often find themselves in a deeper hole than before. A good gut check to decide whether to get rid of these losers is: "If I don't own the stock and I have ample of cash, would I buy the stock today?"  If the answer to that question is a flat "no", then why are you even holding on to that position.

Finally,  don't change your strategy even if others are bragging about their returns. If your friend just made 10% last year while you made only made 9%, do not take more risks because you feel you need to "outperform" your friend.  Also, try to focus less on whether your returns beat the S&P500 or TSX composite (unless you're a professional money manager) and more on whether your investments are making sufficient returns to meet your goals, such as buying a car, home or retirement.

Summary:

I know some may criticize me for suggesting speculation is bad and the focus on the long term is stupid. Everyone is welcome to speculate, but I think the average individual should try to avoid it and only speculate using a very small amount of capital. Thinking long term is not popular, but it works. 

To ensure you can have a long successful investing journey, remember to always to do your homework and avoid getting caught taking on a speculative bet. If you feel you do not want to take additional effort to manage your investments, you can take a more passive approach of putting money in exchange-traded funds (ETFs).  An example is a 50-50 division between equity ETFs (like XIU) and bond ETFs (like ZAG). The use of dollar averaging, the continuation of purchases of an asset over time, helps the passive investor to build a lower cost basis.

Good Luck in your investing journey! As Benjamin Graham would say " in the short run, the market is a voting machine. In the long run, the market is weighing machine. " Try to think a little more long term if you can. (I know it's hard!)

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Other Parts of this Article Series:
Part 2: Intelligent Investing for the Average Investor
part 3: Accounting Frauds, Lessons for investors
Part 4: Understanding Investor Psychology and Improve your Investing Results

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