How to invest - both safely and profitably

 

Possibly one of the most common misconceptions in the world of investing is that higher risks equal higher rewards, and consequently that younger people can afford to take higher risks.

While high-risk-high-reward might be viable in a one-time transaction, it is not a long term strategy. It is a simple matter of probability and mathematics. Over the long term, continuous high risk will inevitably lead to disaster. Thus the first and foremost principle for any sensible long term investor is safety of the principal amount. Like any other business, there are no long-term profits in stocks without safety.

For those looking for a quick short-term profit, race courses and casinos will probably make more sense than the stock market. Horses and cards might be hard to predict but in the short-term, the stock market is downright impossible. You might as well have some fun risking your money.

There is also a common misconception that stocks are risky while other investments like gold and land are safer. But as the recent mortgage crisis should show, anything that can go up can also come down; and quite dramatically. The fact is, everything fluctuates. But as long as you have bought something of tangible value at a reasonable price, you can ignore the fluctuations of the manic depressive mob and rest assured that the market will eventually correct itself and grow.

To begin:

This page is meant as primer for anyone who is thinking of investing money and is new to the world of stocks and mutual funds.
This might be a little long but hopefully it will cover all the basics of what one needs to know to safely and profitably invest one's money.

A stock is essentially a share in a company. Owning a stock gives you a legal share to a company's assets (called Book value) and profits (called EPS or Earnings Per Share).
Stocks are statistically the most profitable of all investments over the long term, because they are legal shares in profitable businesses.
The existence of stock markets provides stocks with very high liquidity, unlike land which requires a lot of paperwork for transactions.
Stocks are also physically safer to own than precious metals and collectibles, especially since most stocks are now in electronic form.
Another big advantage of stocks is the large volume of historical and statistical information available as to their prices and profits. The correct price and performance of stocks can be estimated far more accurately than for any other investment.

In essence, stocks are the most convenient and the most profitable of all investments.
At the same time, they can also be the source of the greatest mistakes and tragedies. Here is what they are and what one has to do to avoid them.

Baa baa black sheep:

The high liquidity of stocks can also be a disadvantage to the uninformed or the unprepared investor. Over the long term, stock markets always rise. They have done so continuously for centuries. But they can go through periods of excessive highs and lows. Investors who are not armed with the knowledge of how to calculate when a stock is too costly or too cheap can end up buying stocks at excessively high prices or selling them excessively low. Investors need to have the judgement to know when the market is being rational and when it not; and be able to take advantage of it, instead of falling victim to it.

The large volume of information can also be a disadvantage. It can cause investors to lose sight of what is essential in favor or what is irrelevant. Investors need to know what information to pay attention to and what to ignore.

In short, the stock market is a bad place for people who follow the herd. It is important to be able to be able to think independently, to hear everyone but to know whom to actually listen to.

Cough cough:

Remember that the noise and chaos in the market is not just based on rumors and emotions, but also largely intentional.

Brokers who work on commissions have an interest in encouraging as much trading as possible, regardless of whether it brings profits to their customers or not, by alternately highlighting good and bad news. Perhaps someday they will charge a percentage of profits instead of transactions, treating investors actually as clients instead of as customers. But until that day comes, you as a customer, need to be on your guard and do what you think is right and not just what you are told to do.

Sub-par companies also have a high interest in obscuring relevant information in favor of irrelevant data which might show them in a more favorable light, even if it is only long enough for them to make a quick profit and shut shop.
The intelligent and independent thinking investor needs to understand that short-term numbers mean next to nothing. Almost any company can be made to look good for a year or two with the help of a few loans and accounting gimmicks. Companies without a long and healthy history need to be selling at exceptionally good ratios to be worth your money.

It's the future, and I see... welfare:

The next most important thing to remember is to ignore all predictions and promises of exceptional future growth. No one in the stock market has any reliable means of predicting the future, especially the immediate future. Decades of research has shown that the short-term predictions of all analysts and researchers put together is less reliable than a coin toss. The final short-term outcome of the stock market is absolutely random.
But these people continue to get away with their story telling because the investing public has such a short memory. There's one born every minute, remember? There's always fresh meat on the block.

The only real way to reliably judge what a company or economy might do in the future is to see what it has done continuously in the past. Rarely, if ever, do things improve suddenly, especially when it comes to large economies and companies.

Things can do downhill suddenly though, fear has always been a more powerful emotion than greed.
But if you have applied the recommended standards of safety to your investments, rest assured that your money is safe. In the long term, the average market always goes up and your investments will eventually recover and go back into profits. A company that has been solid for decades will not go under overnight. The market might undervalue it for a while but it will see sense soon enough.

But if you have not applied any safety standards and invested in one of those fly-by-night operators based on assurances of sudden fortunes, well.. so long and thanks for all the fish.

Make up your mind:

The fact is, the stock market is not intuitive. Instinct and gut feeling count for next to nothing over here. Everything that works great for endeavors outside will fail here. Enthusiasm will lead to disaster. Strong networking and people skills will bury you, along with your network. People have won Nobel prizes for mathematical formulas here, just a little before those same formulas wiped them out (look up LTCM). Trying to use the best of everything will only get you the average of everything, which is usually nothing much. Going by popular opinion will only get you what the majority gets, a big surprise when the market tanks.

You have to make up your mind very early on about what you want.
Do you think you would happy with the same 30% average annual returns realized by legends like Buffett and Soros?
Or you do you think you're smarter than all those old fogies? That you'll be able to do better with your innate brilliance, charming social skills, certified mathematical genius and using the best of all philosophies?

Because, if you are in the second group, GV and Graham are not for you. A little knowledge is a dangerous thing.
A lot of philosophies on the stock market run contrary to each other - Graham probably runs contrary to most - and it's inherently impossible to abide by all of them. The fact is that the stock market is more about common sense and cold, clear logic; and less about instinct, talent or genius.

So assuming you're the mild-mannered Clark Kent from the first group who's happy with a reasonable and safe profit and not interested in any mental gymnastics, let's move on.

So before you hide it all in a mattress:

If all the above has served to scare you a bit, rest assured that that was exactly the intention. You will be playing with fire. Have no illusions about that. But success requires playing with fire. GV is only here to show you how to do it professionally and without getting burnt.
And it's not fools in the stock market who get burnt. The recent spate of crashes, collapses and bailouts of large institutions employing some of the best minds in the world should be ample proof of that.
It's actually the very clever who get burnt.

The fact is, the stock market is a very unique animal. It rises when it should fall. It kicks back when it should be doing something, anything. It gives nice profits with just a little intelligence and effort. But a little additional brilliance and suddenly you're looking at a big joke that used to be your pretty portfolio. Amateurs do reasonably well but professionals lose spectacularly (Remember Bernie Madoff, and all those high flying investment banks?).

The brilliant minds who juggle differential equations in their cubicles know everything about this animal except how to make it understand their equations.

The question is actually very simple. It's obviously not how much risk you are willing to take. The stock market is risky, and to make money you should be taking on as less as possible.
It's not about how clever you are either.
The question is - how patient are you and how much effort are you willing to put in?

Calvin or Hobbes?

They say it is not timing the market, but time in the market that matters.
And for once, 'they' are right.

The below categories of investing styles are classified from requiring the least effort to the most. Note that the highest average returns to be expected from any of these categories is not more than 30% annually which is the highest even the legendary professionals make.

1. Index funds.
Simply find a good, professionally managed index like the DJI or S&P500. Find a fund that just follows it. Invest in it. You will simply get the same returns as all the most reputed companies in the market. That is not actually much less than the below options, and can even be much more.

2. Mutual funds.
This will needs some research work - less than stocks, but more than simply investing in an index fund - because mutual funds rarely beat the indexes. Funds have large salaries and commissions to pay and sometime take unnecessary risks to improve performance. But a reputed and sensibly managed fund will give you the advantage of professional management and avoiding serious mistakes in investments while at the same time maybe finding a few better opportunities than the already over-popular index stocks.

3. Defensive investment in stocks.
Investing in stocks of impeccable reputation at reasonable ratios. Requires a decent amount of effort. GV gives you a ready-made list of defensive stocks but you should verify them. But with this option, you will avoid all the salaries and commissions deducted by mutual funds. Since you need to research reliable mutual funds anyway, you could as well spend a little more time researching reliable stocks yourself.

4. Enterprising investment in stocks and Bargain issues.
Requiring the highest amount of effort. Requires identifying companies that are not blue chips but of good quality nevertheless and selling at very reasonable ratios, lower than even those of defensive stocks. GV again gives you a ready-made list of reasonably priced good quality stocks and NCAV bargain stocks as well - stocks that are selling for less than their liquidating cash value per share, leaving aside additional fixed assets. But again, these stocks need thorough verification before investment too.

In the ugly words of Eli Wallach, how much?

So how much does one invest?

The first and Golden rule of investing is, never invest your emergency money. This is money kept aside for any critical unplanned work or medical emergencies. While it would nice to earn a nice profit on this too, once invested, this money may not be available; say when the market decides to take a quick dip and doesn't resurface for a year. Hence the term, emergency money! This money should always be in cash or cash equivalents like deposits in savings accounts which earn a minor interest but are still available anytime. The recommended amount is about a year's expenses.

The rest of your money is what you should be using to get rich, but don't die trying.
Graham said "an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative".
Note the word "promises". There is no scope for risk or doubt in a true investment. Any operation where safety or returns are doubtful is by definition, speculation. True investment is a business operation, not a game or gambling.

Graham said to buy stocks like one buys one's groceries and that's probably the best analogy. Forget the colorful pictures. Ignore the advertisements and marketing. Look at what's on the label. Healthy food is not incredibly expensive. Stick to known healthy brands. If you're trying something new, make sure you do all the research first. You wouldn't put something in your system just because someone else said it's good for you, would you? If you are what you eat, your wealth is your investments. And your portfolio is actually a lot more sensitive than your body. If you poison it, it'll show the symptoms very very fast.

That being said, Graham advocated the simplest portfolio policy as keeping half your money in fixed income securities like bonds, and inflation-hedging the other half in stocks. The exact percentage can vary based on your risk appetite and - if you're willing to do the math - prevailing interest rates. But the maximum deviation Graham recommended in either direction was 75:25. Incidentally, your emergency fund which is in a savings account or other such similar safe and fixed interest medium can be considered part of the bond component of your investments too.

Mattress still sound better?

Well, frankly, who can blame you?

The point is, the best person to decide what to do with your money, is you. Never trust someone else with your money, especially someone who has nothing to lose by losing your money - whether it is in the form of hot stock tip, or actually investing it for you.

Invest it, hide it or sleep on it. But whatever you do, do it yourself.
It's your money.