Are you curious about learning how to invest in the stock market, but not sure where to start? This article will describe some resources to help you answer some basic questions, and will also describe how I became interested in individual stock investing.
- Why invest, instead of simply saving money in a bank account?
- Should you invest in mutual funds?
- Should you invest in individual stocks – how many should you have in your portfolio?
- How long should you invest for, how often should you trade them?
- How to choose from the tens of thousands of options available?
- How to value a company?
- What approaches have worked for successful investors, e.g. Warren Buffet, Joel Greenblatt, George Soros, Carl Icahn etc., and which ones can you hope to emulate?
- Why invest, instead of simply saving money in a bank account?
The short answer is a better rate of return – however for this there is increased risk, in two forms, potential for loss of some of your capital, and also increased volatility. Firstly, regarding capital loss: as an individual investor, you should consider how the investments fit with the overall picture of your personal finances. An excellent resource on your personal finances is Dave Ramsey – his materials have helped millions get out of debt, budget, take control of their money and build a solid financial future for their families. One of the things I like best about Dave Ramsey is that he understands human nature – how we are seduced by credit cards and debt, and the importance of having a supportive community to really change your financial life for the better. I will talk more about personal finances in other posts. However, I am not following Dave’s investment advice of buying mutual funds, as I am stock picking instead.
Secondly, in terms of volatility, stocks will of course fluctuate much more than a cash investment – and over short periods of time such as 1 year, even if you invest in a diversified index fund such as an S&P 500 fund, there are still reasonable odds that you investment could decline. However, over 5 year periods this is quite unlikely. The bottom line is that you should not invest in stocks, if you are likely to need the money in hurry to over your basic life expenses, since then you will be a forced seller.
Borrowing to buy stocks, and using them as collateral for the loan is quite possibly the worst possible move since you will be forced to sell when the price declines, i.e. at the worst possible time.
2. Should you invest in mutual funds?
Yes – if you do not have the time or inclination to research individual stocks, then mutual fund investments are a good idea, because of their diversified nature, typically holding 100 or more stocks, you will not be subject to as much risk from one particular company failing or having a permanent decline. There is a diversity of opinion on actively managed vs passively managed funds – for a great discussion on this I would recommend the book, ‘The Little Book of Common Sense Investing,’ by Jack Bogle, father of the passively managed index fund and founder of Vanguard. He gives some great insights into why many – actually the vast majority – of index funds fail to beat the market. Warren Buffet has also suggested that low fee index fund investments are a good idea for most investors who do not want to pick stocks.
3. Should you invest in individual stocks, and how many should you have in your portfolio?
Yes – but only if you are prepared to invest time, as well as money! If you love to analyse complex problems, and learn new skills, then it is a great new challenge to get into. This is path I have chosen, for those reasons. In terms of how many stocks to choose for your portfolio, I would say – not more than you have time to study in depth, and know really well. Geoff Gannon/Andrew Kuhn at the Focussed Compounding podcast, recommend a concentrated portfolio of 5-8 stocks, and Geoff explains that the extra benefit in terms of diversification drop off rapidly, as you go from two, to three, to four stocks, etc. I would highly recommend these guys – their podcast covers general investing concepts and any investor could learn from them. They have a great approach and good interaction on the podcast, and you will always learn something new, whether they are discussing superinvestors, reviewing previous stock picks, or talking about mental models and the biases people bring to investing.
4. How long should you invest for, and when should you trade stocks?
For individual stock investing, time for holding the stocks will depend on what your strategy as an investor is – which should follow your temperament, and I would suggest finding out about different investing styles that people have used successfully. There is definitely more than one approach which works, e.g. you could follow Phil Fisher ‘buy and hold growth companies,’ strategy – his excellent book, ‘Common Stocks and Uncommon Profits,’ describes this. Alternatively, you could following a Ben Graham, ‘buy when price is below intrinsic value, and sell when the market reappraises them,’ approach of buying companies, as described in his classic book, ‘Securities Analysis,’ – buy a ‘cigar butt’ company with one puff of life left it it! There are many other approaches as well, e.g. Joel Greenblatt successfully did special situations investing – more on that below. You need to learn from the greats, and decide which approach suits your temperament and skills. One of the best tips I heard from Geoff Gannon was to learn by doing.
4. How to choose from the tens of thousands of stocks available?
Again, I would recommend listening to the podcast, ‘Focussed Compounding’ for a good discussion on this – why they focus on illiquid, overlooked stocks, and special situations. http://www.focussedcompounding.podbean.com. Joel Greenblatt’s book, ‘You can be a Stock Market Genius,’ (which absolutely proves the advice, don’t judge a book by its cover), actually contains some excellent advice on this and practical examples.
6. How to value a company?
If you believe in the Efficient Market hypothesis, then in order to value a company, you just look at the price. I am not a big fan of this hypothesis – as has been said, ‘Price is what you pay, value is what you get,’ – I am firmly convinced that an appraisal of company itself, including factors such as competitive position or moat, stability of earnings, etc., will drive the value. Then the price fluctuations above and below the intrinsic value, give you periodic buying opportunities.
7. What approaches have worked for successful investors, such as warren Buffet, George Soros, Joel Greenblatt, Carl Icahn etc., and which ones can you hope to emulate?
Warren Buffet buys quality companies, in certain sectors which he understands well, e.g financials, insurers, strongly branded consumer goods, etc, at good prices. George Soros trades a variety of financial instruments, including currencies, stocks, options, bonds, commodities and derivatives, and has had excellent compound annual returns over many years. Joel Greenblatt has described various types of investing, e.g. special situations, spinoffs, etc. and also written a book on the ‘Magic Formula,’ investing style – i.e. with the highest earnings yield combined with the highest returns on capital – see his book, ‘The Little Book that Beats the Market,’ for an explanation of this, and also his website for finding Magic Formula stocks, www.magicformulainvesting.com. Carl Ichan is an activist investor, taking large stakes in companies, getting board representation then often causing the board to make a strategic change of direction to realise value for shareholders.
Of these approaches, it is hardest for a small investor to emulate Carl Ichan, and this blog will not attempt to enter the world of George Soros. This blog is more concerned with value investing, and growth investing.
Finally a word about my journey towards investing – despite the many recommendations in the public domain about choosing index funds, and not trying to beat the market, I have chosen the path of individual stock investing, for one main reason – in the words of George Mallory when asked why he wanted to climb Mount Everest, he replied, ‘Because it is there.’ The challenge itself is what I relish – the challenge to learn, develop and grow, to understand investment at a deep level, to overcome cognitive biases many investors fall prey to, to continuously improve, and to reach the summit of superior returns in the marketplace. Unfortunately George Mallory died in the attempt to climb Everest – so that analogy is now over.
If you like to invest in stocks, and analyse the companies in depth, I will be posting my analyses on here and would greatly appreciate comments and feedback – thanks for reading!