Understand the different investing vehicles out there. Indexing is convenient, but I personally prefer to invest in individual stocks because my goals when investing are oriented towards safety, income, and consistency. Many companies from the index fail to meet this criteria. Therefore, I don’t do index investing, because I don’t want to be invested in these companies. The other factor is valuation – when purchasing the index, I cannot choose to buy a company at or below its intrinsic value. I need to buy the whole package paying market price for all companies, which will contain overvalued ones too. Buying any business when overvalued drags return. Plus there’s MER that compounds every year. BUT, investing in individual companies is not for everyone, it takes a lot of time and research, so if you don’t enjoy the process you will be better off indexing. Understand what each type entails to so you can make an informed decision that suits your style, goals and risk tolerance.
Temperament is the most critical skill. Emotions (greed and fear) is what destroy any wealth, at any age, even if one decides to simply invest in SP500 ETF. If at year 9 we have another 2001 or 2008 or 1929 or even 1987, Mr Smart might become Mr Risky in no time. Meanwhile, someone with proper temperament can indeed benefit from what is perceived as Mr Risky, provided that proper controls to mitigate risks (validating that fundamentals are disconnected from stock price) are in place. Anyone can learn it if they put time and effort into it.
If you do choose the route to invest in individual stocks…. then I would give the following additional advice:
Have a diversified portfolio. Nobody knew that GE or C would be so adversely affected to the point that it comprises fundamentals. Like Buffett says, “buy a company so solid that any idiot can run it, because eventually, one will “. My diversification strategy is about having exposure to 10 sectors, and buy the leaders on those sectors.
It’s a business partnership. You don’t measure results in a week or a month or a year. You will know in 5 years from now if you made a good decision, which is about what a business cycle lasts. Track earnings and cash flow yearly, read their earnings transcript and annual reports, become familiar with the industry and business they operate on. When I am investing in a business, I am buying the company’s future earnings power and dividend growth potential. Companies report results 4 times a year only. Hence investing is for the long term, it takes time for stock price to follow earnings. Fundamentals cannot change as fast as the stock quotes, so the daily price quote is just a distraction that needs to be filtered out.
Start small. You can always scale up later.
Stick to your plan. Have it figured out before you buy anything. You should know what to buy, when to buy and when to sell (as a strategy) before you begin. Follow it strictly. One of the primary reasons why investors often make bad investment decisions is because their judgment is usually based only on price movement. Price movements alone can be very misleading. A rising stock price will often lure an investor to stay calm, creating a false sense of security where they believe that all is well. On the other hand, a falling stock price usually creates anxiety and sometimes leads to outright panic. These feelings can be rational as long as they are justified by sound fundamentals. Knowing the differences between rational and emotional reactions will make all the difference.
Mistakes will be made. It doesn’t mean the strategy is broken. What matters is your consistency, so you only make rational decisions, not emotional ones. As Charlie Munger said once: “As long as you are consistent on how you value business, your degree of inaccuracy, if it’s replicated through consistency, will lead to a great model for a relative valuations. So if your valuation model is not sophisticated, does not take into account six dozen variables, well, as long as you’re applying it the same way to every company and you are looking at a lot of different companies, you will have a useful model for relative valuation which can lead to very superior investment returns.”
Investing is a business, and like every business, there will be period of locking losses. However, a diversified portfolio built consistently seeking quality and valuation will always deliver superior results, with winners higher and more often than losers. The big risk of total loss associated with equities (on a diversified portfolio built with quality and valuation in mind) is quite rare, and more fear-based than fact-based. Furthermore, the risk associated with a falling stock price, especially when the underlying business remains strong, is more related to investor action than pure loss. In other words, the greatest risk of a falling stock price is how the investor reacts to it.
You don’t lose one cent until you sell. There will be bear markets, recessions, negative market sentiment. Separate the erratic moods of Mr. Market from the financial health of each business. Hence investing is for long term, you need time to find out how management will react and adapt to continue growing earnings and cash flow. It’s their job to figure it out, not the analysts or yours. Yours is just to allocate capital.
Don’t monitor it daily. Investing in dividend growth stocks makes money while you sleep. Don’t stress over it, give time for fundamentals to reflect on stock price. Any business public or private, derives its value based on the underlying performance that the business generates. These value drivers include, but are not limited to, operating results such as earnings, cash flows, sales (revenues) and dividends. Common sense tells us that the true value of a large multinational business, or any business for that matter, cannot possibly change as quickly or as much as daily price quotations would indicate. Stock prices in the short run can be driven by strong emotions such as fear and greed. The intrinsic value of a business is driven by fundamentals and can be calculated within a reasonable degree of certainty. Once this calculation is made, sound investing decisions can be made and implemented.
Being a value investor is more about discipline than it is about intelligence. We can’t control price fluctuations, but we can control the quality of the companies we purchase. The higher the quality, the more confident I am that the company will bounce back on any price drops.
Successful investing is about managing risk, not avoiding it. No business is capable of generating perfect long-term operating results. Inevitably, there will be a bad year, a bad quarter, or even a few bad years or bad quarters. However, a weak quarter or year does not necessarily imply that a sound business model is no longer valid. Businesses are competitive, economies are cyclical, and good managements respond and adapt. That’s why I wait at least 4 or 5 years of declining earnings and estimates that continue to decline before I decide to sell (what I call “ceasing the partnership with that business”).
Read The Intelligent Investor by Benjamin Graham and Common Stocks and Uncommon Profits by Philip Fisher the annual letters to shareholder from Berkshire Hathaway. Tons of consistent wisdom there, like this quote from 1988 letter: “In any sort of a contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try”. Or this quote from 2014 letter: “Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
Most importantly: have fun. Investing is a journey, never a final destination, so enjoy the process while you learn and get better at it. It never ends.