How the Stock Market Works | Animated Video by the New York Stock Exchange (1952)
Investing is the preservation and growth of wealth. If you have 1 million US dollars, consider investing in a very safe income-generating asset such as 30-year US treasury bonds for a gross annual return of ~3%, which yields $30K per year. If you have a spare 25K dollars, consider investing in a moderately safe income-generating asset such as bonds and dividend stocks for a gross annual return of ~4 to 5%, which yields $100 per month. If you want to invest 10K dollars aggressively (aiming for ~6 to 10% annual growth) but don't want to spend much time on it, consider letting exchange-traded funds (ETFs) and mutual funds invest your money for you, whether actively like strategic funds or passively like index funds. If you want to invest 5K dollars directly by yourself (aiming for ~10% to 10X gains over the short-term and medium-term), you should prepare a lot of research so as to avoid tragic mistakes.
Investing is available in different forms and provides the economic flexibility to tackle specific goals. Investing usually involves the accumulation of tangible assets such as stocks and real estate, but can also cover intangibles such as personal development and home insurance. Investing enables vacations, hobbies, home ownership, retirement, entrepreneurship, and philanthropy.
The ultimate principle of investing is to correctly evaluate the useful value of different assets to yourself and others across the short-term and long-term. An old car can still provide convenient, reliable transportation as long as it has fuel and maintenance, even if its market price has plummeted long ago. Stocks provide a continuous stream of income as long as the business is making a profit and issuing dividends; it doesn't matter if a stock price goes down as long as the business itself will be doing great into the foreseeable future.
Gross Return vs Real Return
Gross return is the raw gain. $100 to $120 is a 20% gross return.
Real return is the gain adjusted for purchasing power. $100 to $120 across 2% inflation is a bit under 18% real return.
Rate of return is usually stated as a gross yearly value.
Rate of Return Spectrum
Negative % - Cash. Currency loses purchasing power over time with inflation. Governments strive for a small amount of inflation in order to keep money circulating while avoiding the economic dangers of deflation and hyperinflation.
0 to 1% - Bank savings accounts. Short-term federal bonds. Very safe in developed countries like the United States.
1 to 3% - Medium and long-term federal bonds. High-grade short-term corporate bonds. Still very safe in developed countries and established companies.
1 to 4% - Wealth assets; land, precious metals, real estate, and durable tools. In a stable market, they gain at least on par with inflation. Excellent for wealth preservation, considering the longevity of territory/noble elements and the usability of homes/equipment. But financial rate of return may vary with advances in technology, shifts in demographics, and political/legal tension.
3 to 5% - Dividend stocks of established companies. High-grade medium-term corporate bonds. Safe.
5 to 10% - Growth stocks. Low-grade bonds. Low-growth dividend stocks. Risky.
10% and up - High risk growth stocks (ex. biotech). Declining dividend stocks (ex. coal). Junk bonds. Self-driven entrepreneurship (ex. new franchise store). Very risky.
Fundamental Analysis vs Technical Analysis
"Fundamental" Analysis (FA). Evaluation of the intrinsic rate of return; a deep perspective that, for example, looks at the gains if you hold a stock and never sell it. Most of a stock's intrinsic value comes from the assets of the business and the dividends from the growth of its revenue/earnings and the maturation of its market share. Competition, industry trends. Helps you find undervalued investments.
"Technical" Analysis (TA). Evaluation of market patterns; a shallow perspective that can be effective for quick buying and selling for gains, but harbors much greater risk of sudden, irrecoverable loss. Hype, sentiment, price movement. Helps you pinpoint good entry and exit points.
Considering All Numbers
An intelligent investor calculates all the numbers that matter, including trading fees and fund management fees.
Example: If you buy $100 of stock through a brokerage that charges $10 per trade, you need that stock to go up by 20% just to break even with your buying fee and selling fee.
How do you evaluate stocks?
A lot of people enter the stockmarket with a simple gusto to buy low and sell high. While that line of thinking is not inherently bad, it represents an unhealthy obsession with the price movements of a stock rather than its fundamental value. You wouldn't buy a part of a convenience store when it's priced at a billion dollars, but that's a real risk when investors are blind to company fundamentals. That leads nicely into the main point here: the fundamental value of a stock is about how much money you can earn without selling it. Thus, for the average investor, the fundamental value of a stock has everything to do with the future expected dividends of the company. I'd go as far to say, dividends are the most important pillar of intelligent stock investing.
What about the book value of the company?
Book value is interesting because it is practical and misleading at the same time. If a company has no debt, equipment worth a million dollars, and a 500K market cap, then you could theoretically acquire and liquidate the company and make a profit as long as you sold the equipment for at least 50% of book value. Yet the average investor has no such power. An average shareholder also has no guarantee that a company with excellent net assets today will decide to liquidate before they tumble downwards too much. It is common to see companies struggle for a while before they declare bankruptcy, pay their employees, pay their secured and unsecured creditors, then leave nothing for common stockholders. Furthermore, to consider book value alone harbors a pessimistic outlook on the company where liquidation stands out as the primary way to make money. The correct way to consider book value is as a supplement to dividend forecasting; a backup store of value in case things go unexpectedly, and as a measure of capital, equipment and otherwise, that can be used both for business operations and as collateral for long-term debt.
How would you evaluate companies that do not currently issue dividends?
Such companies are usually in their growth phase or experiencing turbulent years due to market saturation or a cyclic downturn in the industry. These stocks have value because they are expected to grow or recover, then eventually issue dividends. Your analysis should focus on forecasting the earnings per share (EPS) trajectory of the company, supplemented by an estimate of the anticipated dividend payout ratio (DPR). The result will be your forecast of the company's dividend payout curve over time. Now you can determine what share price would produce a reasonable average dividend yield into the future. Importantly, note the period of time that you have to wait before the company starts issuing dividends. These zero-dividend years cut into the average dividend yield, which combine with the risk associated with early-stage companies to be the compelling reason why growth companies are appropriately priced attractively during their formative years.
What do you think about index funds?
They've certainly been popularized over the past decade. I don't think enough people understand their risks and composition. New investors don't want to miss out on a bull market so they get whisked into index funds rather blindly and without considering the all-important price factor. It's because the average investor is understandably doubtful of most active funds from their subpar performance, and also doesn't want to deal with the hassle of trying to time the market. Yet investors must realize that while index funds have performed well historically, their bandwagoning today has produced grossly overvalued stocks and momentum toward a heavy correction. People can't keep buying businesses regardless of price and expect the hidden gems to always offset the overvalued and failing ones. Indeed, the more people buy index funds, the more their average rate of return diminishes.
How should the average investor consider index funds?
First they should really understand what an index is, and how index funds assign weights to each stock depending on key metrics such as market cap, revenue, earnings, assets, and dividend yield. Index funds offer plenty of diversification, so you're pretty well protected from the risk of losing everything. Also, if the index contains dividend stocks, you can be fairly sure you'll get some rate of return off them. Other than those, index funds offer no more guarantees as long as investors are blind to price. The paradox of index funds is that you want to buy when the price is right, yet determining that is impractical to do across all stocks in the index. So you always have a more incomplete and wider picture of the fundamentals for index funds than, say, a group of 10 stocks. Index funds really depend on the market of each stock to hold an appropriate price for their risk and return expectations.
Do you recommend index funds?
I'm not sure. Index funds seem fine in general as long as enough of their constituent stock prices are reasonable. Broad index funds are good during a bull market driven by real economic growth. Narrow index funds are excellent when a particular industry or sector experiences non-zero-sum earnings growth. Overall, investors should know that the fundamental return of an index fund comes from dividends and positive weighted-average earnings growth, minus capital loss from companies heading towards bankruptcy. Personally, I avoid index funds because of their incomplete fundamental picture. For the average investor, it's tough because their options are limited. Over-valued index funds, under-performing active funds, or unskilled self-selection? Frankly, the blind passivity of index funds risks mediocre returns, while the ambition of self-selection often yields volatile results, some tragic. I'd recommend most people to just find a smart active fund led by truly smart people, or go for a hybrid portfolio between passive and active fund allotments.
What do you think about options?
Put shortly, the average investor doesn’t need to deal with options at all. Don't worry about it. Options can be a cost-effective way to profit from stock price fluctuations. However, options alone bear an extra layer of risk due to their dependence on market price and a limited time period. You see, in order to make money off options, the price of the stock needs to move in a certain direction- up or down or sideways- within a certain period of time. Meanwhile, stock prices can often get quite detached from rational business expectations. So even if a business reports excellent performance, the stock price might not rise for a while because people are scared for the uncertainty of the future. Your call options are simply not guaranteed to yield a return even if your projection for the business is correct. The same applies for put options. Even if you correctly anticipate company failure, the stock price may not fall for quite a while because people are hopeful for a recovery. Stocks are generally more robust than options because stocks last forever (as long as the business is alive); also, it's easier to buy shares from the stock market than deal with options in the derivatives market. Therefore, I recommend that straight-forward investors simply stick with buying stocks to ride on success.
Wouldn't you agree that stock prices eventually correct themselves over time?
Yes, prices do eventually correct and normalize into a reasonable range of risk and return. However, because options are contrained by a time bound, even options with long exercise periods may fail. Consider a put option for a company destined to lose significant market share, for which the stock price remains stubbornly high for years due to irrational investor confidence.
Is there a way to account for this extra layer of risk?
You'd have to consider signals, sentiment, and alternative investments. Signals are like quarterly earnings reports and partnership declarations. They are objective drivers of demand for the stock. Sentiment involves popular opinions and prevailing conclusions such as peak oil and rare earth mineral shortages. Even a company destined for success may have a few bad quarters, get marked by poor sentiment requiring contrarian confidence, or float low during times of incredible returns in other sectors.
Are any option strategies worthwhile for the average investor?
Absolutely. The way I recommend you use options is to protect an existing stock position. By holding put options during turbulent times for the company, you have a simple way to cut your losses in case something really bad happens. This can be particularly useful when awaiting important company results with an announcement in the near future. The tradeoff is that you make an up-front payment for the put option, cutting into any future gains from company success. Another strategy is to normalize the gains of an existing stock position by selling call options. Though, the compelling disadvantage of selling call options is that you may be forced to sacrifice a well-priced long position on the company. All that said, the average investor doesn’t need to deal with options at all.
Exchange Traded Funds (ETFs)
An ETF is just a collection of stocks or bonds that is registered to be bought and sold in pieces on a public exchange platform. They incur an annual management fee, usually between 0.1% and 0.5% of the fund's net asset value. ETFs come in different types, such as passive indexing, active management, active trading, and AI-driven trading. The price of an ETF generally mirrors the individual prices of its holdings, but sometimes distorts during low periods of arbitrage interest in price correction and undervalued ETF redemption.
Passive ETFs are a cost-effective way to diversify risk into multiple stocks when you don't have a lot of money. With low capital, the annual fee of a passive ETF can be strikingly lower than the broker fees associated with buying and selling several different stocks individually (plus the extra time required to do so). Conversely, if you have a lot of money and interested in a relatively small group of stocks, you'll stand to save a lot of money by just buying the stocks yourself. For a large portfolio, a passive ETF only makes sense if you are directly investing by yourself and want to save time on placing orders, re-weighing, and re-balancing across a large number of stocks.
Active ETFs are a convenient, liquid alternative to mutual funds as a way to get your money managed and invested by tentatively smart people with custom strategies and decisions. Whereas the direct, manual process of engaging a mutual fund company is more appropriate for long-term investment, ETFs are much easier to buy and sell through your brokerage.
Recommended Investing Principles
Liquidity: Keep enough money in your savings account for emergency purposes before you start investing. You don't want to be in a situation where you're forced to choose between taking an immediate 10% loss on selling your investments (during a downturn) or accruing sizable credit card debt while you wait for your investments to recover.
Composition: Preserve at least 30% of your portfolio in defensive investments such as dividend stocks and bonds.
Transaction: It is better to execute a great trade successfully than to miss the opportunity trying to optimize the price.
Actualization: Get into the habit of selling your stocks to take your gains; also, generally avoid selling at a loss ever. The investing dance involves those who sell too early, and those who sell too late. It is better to bias yourself towards the former- better a small gain than a large loss. This is the most emotional principle, filled with regrets about having sold at the wrong time or having waited too long. Just be resolute with the decisions you make.