Author Topic: Investing, Simply Explained  (Read 2728 times)

ValueIsWhatYouGet

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Investing, Simply Explained
« on: May 11, 2015, 02:46:04 PM »
I've found that some common investors (some of which are on this sub) have a deeply flawed approach to investing. Investing is not "will this company sell more products in 5 years" or "will marijuana be legal"? These are predictions/speculation, not investing, and without knowing the difference, your returns are going to be below average. I wrote up a little primer on investing on my blog http://www.valueiswhatyouget.com, and wanted to share it below for anyone who might be new to investing.

For what it's worth, I used to think I knew what I was doing when it came to investing, until i spent thousands of hours reading and further educating myself. Then I realized I was purely speculating and had no business investing in individual stocks. The aim of this post is to help put people on the right path, so hopefully you find it useful:

What is Buying a Stock? (A Primer on Intrinsic Value)

It's a foregone conclusion that the common investor regularly underperforms the market. Maybe it's their emotions getting in the way, or they can't see their own ignorance, or perhaps some combination of the two. While these, and many other faults, are surely prevalent, they are not the greatest impediment to healthy returns. Instead, there is a fundamental misperception behind the concepts of both shares and stocks that must be remedied if one wishes to achieve consistent returns. I believe that:

  • The common investor doesn't know what "a share" fundamentally represents.
  • There is a perverse disconnect between a company and its stock

By not understanding these two basic (yet often taken-for-granted) concepts, an investor has no business investing in anything but an index fund. At the most fundamental level, an investor has to understand that when buying a share of a company, what you are really buying is a percentage of the company's total worth. It therefore follows that the right question to ask isn't "will this stock price go higher" but rather "what is this company worth" (and can I buy it for less than that)?

So What is a Share?

We can easily look up the definition of a share, and find that it's "one of the equal parts into which a company's capital is divided, entitling the holder to a proportion of the profits." Sounds easy enough, but for those who don't have a solid accounting or business background (i.e. the common investor), this is far less clear than one might think.

I've often seen the mistake of 200 shares being ipso facto "better" than 100 shares. While some might laugh and say those people are foolish, this belief is surprisingly prevalent. I know many who view the share price as being indicative of how "good" a company is. It's fairly commonplace to think that Company A, priced at $50/share, is a better company than Company B, because it's at $20/share. Sillier yet, people will avoid Company A, because it's "more expensive" than Company B (at least on a per-share basis). People fail to grasp that when you buy a share of stock, what you're really doing is buying a piece of that business. Owning a share entitles you to claims on the cash, assets, and future profits (and losses). Put more simply, a share is nothing more than a percent ownership of a company.

To make it easier, think of it like a pizza. Would you rather have 1 slice of a pizza pie or 12.5%? Well, that all depends on how many slices are cut from the pie. If the pie is only cut into 4 slices, then 1 slice represents 25% instead of the measly 12.5%. Extending this same logic to shares of a company, we now know that the actual number of shares really doesn't matter. What does matter is the percent of the business a share represents. All things being equal, 1 share of a company with 100k total shares available is very different than 1 share of a company with 10k shares.

Company vs. Its Stock

Now that we know that a share represents a percentage of ownership, we have to ask "what is this company worth?" No doubt, this is an intimidating question. Do we add up all the assets? Do we look at the cash in the bank? Do we look at future profit? How do we account for untapped markets, technology shifts or unreleased products? There is no simple answer, but answer it we must. People spend too much time trying to predict the upward or downward squiggle of stock price instead of trying to make sense of what a company is worth, but once we determine the worth of a company, it's easy to figure out what to pay per share.

It helps to look at a very basic example. Let's say you were offered an opportunity to buy 50% of a company. You've done your homework, and know that this company owns a building worth $10m alone, in addition to some other profitable operations. There are only 2 shares of the company available, so what would you pay for 1 share? Well we know the company is at least worth $10m (from the building), so all things being equal, we'd likely jump at the offer to pay anything significantly less than $5m for 1 share (i.e. 50% of the business).

Now say there are 100 shares available. Would you still pay $5m for a single share? Probably not because one share now entitles you to a mere 1% of the company; or $100k. It's obvious that paying $5m for $100k of value is not a prudent decision, and this is exactly the same type of mental exercise an investor must go through when deciding on whether to invest in a company.

After this slight change in mental framework, we can move on to the hard part; how to value a company. This is the fun (and difficult) part, and we can get there many different ways. Maybe we add up everything the company owns and owes, what they take in/pay out in cash, and then trying to figure out what all that is worth. Or we could only look at the balance sheet (where assets like real estate, equipment, cash and investments live). Further still, we can try looking at future earning potential of the company, and figure out what those earnings are worth today (this is called discounting, and you must understand it intimately)

Conclusion

It's vitally important to remember you're not betting on whether a some little squiggly line will go up or down, nor are you estimating exact future sales figures. In the purest, most simple form, the only thing you should be trying to answer is "what is this company worth?". ​If you cannot do this, you should not be investing in anything other than index funds. I would recommend Vanguard's.

forummm

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Re: Investing, Simply Explained
« Reply #1 on: May 11, 2015, 03:37:47 PM »
<lots of content>

If you cannot do this at least as well as professional investors, you should not be investing in anything other than index funds. I would recommend Vanguard's.

Added my take in red.

Indexer

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Re: Investing, Simply Explained
« Reply #2 on: May 11, 2015, 06:46:53 PM »
<lots of content>

If you cannot do this at least as well as professional investors, you should not be investing in anything other than index funds. I would recommend Vanguard's.

Added my take in red.

+1.  It should probably read at least 'better' than professional investors... since they tend to underperform the index funds anyway. 

According to Lipper 93% of Vanguard funds outperformed their peers(the professionals) over the last 10 years.  No work at all = top 8% of (professional)investors.  Tons of work and headaches = 93% chance of being in the bottom 93% for the 7% chance of being in the top 7%.  Seems like an easy decision to me.

forummm

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Re: Investing, Simply Explained
« Reply #3 on: May 11, 2015, 07:46:59 PM »
<lots of content>

If you cannot do this at least as well as professional investors, you should not be investing in anything other than index funds. I would recommend Vanguard's.

Added my take in red.

+1.  It should probably read at least 'better' than professional investors... since they tend to underperform the index funds anyway. 

According to Lipper 93% of Vanguard funds outperformed their peers(the professionals) over the last 10 years.  No work at all = top 8% of (professional)investors.  Tons of work and headaches = 93% chance of being in the bottom 93% for the 7% chance of being in the top 7%.  Seems like an easy decision to me.

I actually started with "better" but then decided to be more generous. There are a lot of reasons why 99%+ should just index. Even a lot of the pros index.

innerscorecard

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Re: Investing, Simply Explained
« Reply #4 on: May 11, 2015, 08:30:04 PM »
You do not need to have the same resources or abilities as professional investors if you are looking at securities that are uninvestable for them because they are too small or illiquid.