Unfortunately, Wall Street as a whole has done everything possible to convince us that we’re not smart enough to control our own investment accounts. They stress that the only way to succeed in the stock market is to hire their “expert” money managers, who they say will have your best interests in mind when choosing investments, but more often than not put you in investment vehicles that either pay them high commissions, or end up under-performing the overall market year-after-year, or both (double whammy). Oh, and we get to pay this money manager a fee for losing our money.
Putting our entire retirement future in the hands of some “expert” stranger seems rather absurd, but millions do it every day. I’m truly discouraged by the fact that the majority of the population are exposed to the stock market in some fashion yet know very little about investing, what makes companies valuable, or the stock market in general.
So let’s start with fundamentals.
What actually is a stock?
Just as if you owned your own private business, owning stock entitles you to various aspects related to the business. Perhaps most importantly, you get your fair share of the profits. Depending on the company, the board of directors may choose to issue some of the profit back to shareholders in the form of dividends. These are cash payments paid directly to your brokerage account in quarterly or even monthly time frames. Other companies may choose to re-invest the profit back into the company. The hope there is that the company can use the re-invested profits to grow, expand, and increase their overall value.
Think of Netflix. They don’t currently pay a dividend because every dollar of earnings (net income) is re-invested back into the company to support their growth. Their total revenue almost doubled in the three years from 2012-2015. Meanwhile, Microsoft is a much larger, much older company that is no longer in the high growth phase. They decided to pay out some of their earnings as dividends, rather than keep them and risk not being able to re-invest them to create equivalent or greater shareholder value.
In addition to the profits, you have the right to attend annual shareholders meetings with company leadership, and to vote on matters pertinent to the company, such as a vote to assign someone to the board of directors.
Just as you couldn’t buy and sell your personal small business 10 times in one day, you shouldn’t do this with stocks either. While there are plenty of day-traders out there, don’t be fooled, it’s a losers game and it’ll destroy your finances. Always purchase a stock with the mindset of, “I respect this company. I think it has strong management, and I want to own it.” That takes research.
What drives the price of a stock?
In the long run, the price of a stock is driven by the earnings of the company, pure and simple. Every three months a company will release its latest quarterly operational results, commonly known as the “Financials”. These financials give a snap shot of the company’s business strength (Revenue, Profit, Assets, Debt level, etc.)
What investors really look for is earnings growth. Is the company growing from year-to-year? Are its top line revenue, and bottom line earnings both increasing? A growing company will ultimately increase in value, and therefore command an increasing stock price.
The fortunate thing is that over the long run, it has been shown that this constant daily fluctuating basically cancels itself out. John Bogle, the founder of Vanguard, has a great book that explains all of this. The problem is that the speculation can move markets for extended periods of time, we’re talking years, and if the market finally comes to its senses the year before you’re set to retire, taking your 401k with it, you’re hosed.
That’s a risk everyone takes by being in the market, and why I feel so strongly that everyone should be monitoring their portfolios on at least a monthly basis, and taking profits off the table when the market is running sky high and business fundamentals don’t seem to be matching.
How do people get burned in the stock market?
The complacency aspect is when we put out portfolio’s on “autopilot” as some famous financial heads like to say, forget about it, and then get taken by surprise when a market correction takes it down. For example, during the late 1990’s Dot-com bubble all stock values increased dramatically due to strength in the internet sector, which by the way was all fake. There was no strength. There were companies with market values of over a billion dollars that had no earnings and lost millions of dollars every month. The complacency problem is that many weren’t even invested in internet stocks, but didn’t bother looking at what they did own to determine if their increasing prices were justifiable. Many others purchased these "hot" internet stocks without doing any research to determine if the actual companies really were justified in being the most expensive in the world at the time. Ultimately, when the internet stocks collapsed, they took everything else down with them.
When the stock market is screaming higher every day, it’s easy to get wrapped up in the hoopla and forget the difference between investing and speculating. If a company’s share price increases by 50% in a matter of months they had better of released some news, had a great increase in earnings, or had some other quantifiable reason. If it screamed higher because the entire market screamed higher, there is a good bet it’ll revert back to where it should be based on its fundamentals.
Aside from complacency more often than not people get burned because they forget was a stock is. That’s it. They start trading it like they’re in Vegas, trying to call what it’ll do today, or tomorrow, instead of looking at the big picture. They buy penny stocks of companies on the verge of bankruptcy with the hope of hitting the stock market lottery. They dive into stock options having little understanding of their inherent risks.
Generally, if the overall world economy is great, everyone has jobs, everyone is spending their hard-earned income on cars, watches, and purses, stock market prices will increase, because company earnings increase. However, it won’t last forever. Eventually, economies get overextended, credit becomes harder to obtain, and earnings growth slows or contracts. Stock prices top out and more than likely begin to decrease to adjust to the new growth expectations. Yes, this is extremely simplified, but it makes the point. While the long term trend of stocks is positive, the market always goes through cycles of expansion and contraction.
So which stocks should I buy?
The easy answer is that you own all of them. You don’t worry about trying to determine the value, and resulting purchase price, of any individual company. You let the little heads running around the stock market floor do their thing, and you walk away with the average performance of the market as whole. Essentially, you’re not trying to beat the market, just match it. The absolute best way to do this is through Index Funds, and you don’t need a financial advisor to do this. You can open an account directly with Vanguard, Fidelity, etc and immediately invest in index funds. Get rid of your money managers!
An index fund is a low cost mutual fund whose portfolio of stocks is constructed to match a market index. For example, the S&P 500 market index consists of 500 large companies. While it’s only 500 of thousands of companies, it’s generally considered representative of the market as a whole. You can buy index funds that track the S&P 500, such as the Vanguard 500 Index Fund (VFINX)
Index funds are generally much cheaper than managed mutual funds because they’re computer algorithm driven. They track whatever index they’re attached to and don’t bother trying to play the guessing game of which stocks will be hot this month. The VFINX fund charges 0.16%. If you invest $10,000 dollars, they charge $16 per year in fees. Managed fund fees can be more than 10x that cost, on top of the fees you’re paying to the financial advisor who put you in it.
Statistics have absolutely shown that over the long run, index funds outperform managed funds every time. There is just no argument. Anyone investing their money with a managed mutual fund will most likely come out behind someone who invested in index funds.
Can I make more money purchasing stocks individually?
If you don’t know what a Discount Cash Flow model is, you probably shouldn’t be buying individual stocks. How will you know how much to pay for them? Right now Apple is selling for $108 per share. Is that a good deal, is it fair valued, or is it extremely overpriced? Without knowing how to properly value the earnings, and financial stability of a company, you’re gambling when you purchase stock. That’s not investing.
I personally love to conduct company research. That is why I developed my Stock Analyzer tool that’ll automatically pull the pertinent information and present it to me. I also read the annual and quarterly reports that the companies publish to dive even deeper into the raw numbers. After hours of research, I generally have a good idea of what I believe the company is worth. Only then do I look at the stock price. If it’s below my calculated value, I’ll consider buying it. If it’s sky high, I’ll file away my research and wait for it to drop. Until then, I do nothing.
For now, if you’ve never studied investing, I’d stick with Index Funds. However, if you’re willing to put forth the time and effort required for individual stock picking, then go for it. By the way, my tool will absolutely save you time in conducting this research (Shameless plug).
Lets wrap it up so you can get to taking control of your own accounts*.
- Get rid of your financial advisors or money managers and take control of your portfolio.
- Purchase Index funds through Vanguard, Fidelity, or any other major brokerage houses. Just make sure you pick funds with low fees, and don’t invest everything into a single fund. Preferably, pick one that covers the market as a whole such as VFINX and VTSMX, then grab a bond fund (ex: Vanguard Intermediate-Term Index – VBIIX), and a treasury fund (ex: Vanguard Intermediate-Term Gov’t Bond –VSIGX). Basically, three funds are all you truly need and you’ll most likely do better than the majority of investors.
- Decide how much risk you’re willing to deal with.
Number 3 is the hard one. If you truly have no interest in trying to determine the strength and stability of the overall stock market, then you can “set it and forget it”. You can set automatic deposits to your three index funds, and go on with your life. You have to accept that if the stock market drops significantly, your portfolio will drop with it. It could be 10%, or it could be 50%. If you’ve got 30 years before you’ll need the money, maybe it’ll work out for you. If you’re retiring next year, I wouldn’t trust it.
My recommendation is to start doing some basic research on the overall economy, maybe a couple hours a week, paying particular attention to earnings season, and whether companies are showing revenue growth from quarter to quarter. Pay attention to the market sectors that are missing or beating earnings expectations. Read what’s happening around the world in other countries; are their economies strong? If the market is increasing, try to get a feel for what’s driving it. Is it because of increased company revenues? Is it because bonds are paying so little? Is it because the Federal Reserve injected billions to try to stimulate the economy (search Quantitative Easing)?
Consider taking profits off the table when the market is running extremely high. Which means you transfer money out of the stock fund into the bond or treasury fund. The treasury fund is the absolute safest, but its returns may not even keep up with inflation. It’s always better to lose out on a 10% gain, than stay in the market and have it drop by 40% or more.
Gaining some basic knowledge will help you determine how much money to allocate to each of the three index funds. To start with, in today’s market, I’d invest no more than 50% in the stock fund, the market is extremely high (meaning expensive)**. I’d then put 15% in the treasury, and the remaining 35% in the bond funds. If the market drops, you’ll at least be partially shielded.
Finally, for those of you willing to put in the extensive effort, individual stock picking can be rewarding, just don’t lose your discipline. Make sure to ignore all the talking heads on television, they won’t have you’re best interests in mind.
Here are some investment websites you can use for research.
The Wall Street Journal
*Obviously this post is my personal opinion and is for informational purposes only. There are risks involved with investing including loss of principal. I don’t know your specific details, therefore this isn’t a recommendation to purchase any of the index funds listed, they’re just examples. There is no guarantee that the goals or strategies discussed will prove beneficial. Consult with a trusted professional before making any significant changes to your portfolios.
**In my opinion the market is extremely expensive, based on the fact that the market is hitting all-time highs while company earnings have been decreasing, among other worldwide problems. My next post will discuss my take on today’s current market in more detail. Many people would disagree with me and think the stock market is completely stable.