The ultimate Q&A to Investing 101

Investing tips 01: This is part of a series of investing advice that has been collated from my Quora responses. I have updated it to provide a bit more information on what is investing, why invest and why invest in the stock market. Revision date: 4 Aug 2021

Investing strategy 101
"An investment in knowledge pays the best interest."  Benjamin Franklin


When it comes to investing in the stock market, many newbies look for stock tips. I differentiate between stock tips and investing tips
  • A stock tip is a piece of advice on which stock to buy or sell
  • An investing tip is a bit of advice on how to invest.

The best analogy is fishing. A stock tip is about giving you a fish. An investing tip is about giving you some advice on how to fish.

This post is the first in a series meant for newbies.  I focussed on answering the questions from the view of a bottom-up, stock-picking, long-term value investor.  

I am coming from the perspective that you are interested to learn how to invest based on fundamentals.  This requires you eventually to analyze and value companies. 

If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is  The Motley Fool. Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you. Learn more.



Contents

1. What is investing

2. Why invest

3. The investment universe

4. Investing in the stock market

1. What is investing

  • “Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit.” Investopedia
  • “Investing is the process of buying assets that increase in value over time, with a goal of generating income or selling for a profit.” Forbes
  • "…the process of laying out money now to receive more money in the future.” Warren Buffett in Fortune

You can see from the definition that investing is about putting your money to work. 
  • It is not tied to any specific asset.  You can invest in different assets.
  • You can learn to invest at any age and start at any time.
  • It is not about the amount of money you have. There are ways to invest if you don’t have a large amount of savings. 

Investing is different from saving. Saving is about amassing money whereas investing is about multiplying it. Investing is riskier than saving money. Savings are sometimes guaranteed but investments are not. 

Since there are many types of investment to choose from, the first question that newbie ask is how much should be allocated to each.

1.1. How much of a person's savings should be in stocks?

If you consider investing as a way to protect the purchasing power of your savings from being eroded by inflation you should look at allocating your savings from a global perspective.

I suggest that you divide it into 3 groups.
  • Liquid assets eg bank savings to serve as emergency funds so that you are not forced to sell the other assets at the wrong time. I have 2 years of annual expenditure here. The amount here will depend on your own circumstances.
  • Safe assets eg those that protect the principal such as govt bonds. This serves as the floor net worth in case all your risky assets tank. This also serves to generate returns at times when the other risky assets don't perform. I have another 8 years of annual expenditure here.
  • Volatile or risky assets eg stocks, real estate. These have the best historical returns. The balance of your savings should be here. I have an equal amount in stocks and properties because in Malaysia both have similar returns.

The above is an attempt to balance between maximizing returns and playing it safe. It does depend on your current earnings and risk tolerance.

The logic is that risky assets require time to “mature” so you don't want to be forced to sell at the wrong time to meet some cash emergencies. At the same time, you have about 10 years of net worth to ride out any business cycle.

And from Ray Dalio's all-weather-concept (ie we protect against two critical economic conditions - inflation vs deflation and growth vs recession - the 3 buckets cover all 4 combinations of the economic situation).

The point is that you re-balance the bucket every year based on what you have saved from your income and as your expenditure pattern changes over time (with marital status, higher income, etc)

2. Why invest

You invest to prevent the purchasing power of your savings from being eroded by inflation. If you don’t invest, there is a risk that you will see a reduction in the value of your savings.

From this perspective, the only reason you don’t invest is that you do not expect inflation in your country.

One of the reasons cited by many for not investing is the fear of losing money. Many forget that by not investing, you will also lose money through inflation. 

Of course, to hedge against inflation, your return has to be greater than the inflation rate. If you are not able to achieve this, the value of your money will also decline. So, there is a minimum return that you need from your investment. 

If you get a return that is greater than the inflation rate, you will grow your wealth. If you are aiming to generate some positive return, then shouldn’t you try to achieve as high a return as possible?  

To summarize then, there are two main reasons why you should invest
  • As a hedge against inflation.
  • To grow wealth by achieving a rate of return that far exceeds the inflation rate.

2.1. I made too many day-trades and my account says I am short over 20,000, what should I do?

There are a few ways to think about investing:
  • Buy and sell pieces of paper.
  • Buy and sell part ownership of businesses. 

If you are not good at reading human behavior or understanding business you can choose indexing or factor investing. This is some “diversified " approach that also works.

Given your results, you should figure whether you have the mindset to read crowd behavior. All the trading rules, charts, trend lines, and technical indicators are just proxies of market behavior. Knowing the rules will not help if you are not cut out for it.

I have tried both fundamental and technical approaches and found that I could not make money with technical. But I am a successful value investor. I think it has to do with mindset. I keep seeing patterns that with hindsight are wrong.

Nowadays I am more inclined to think that you have to use an approach that is in tune with your mindset.

Some people are artistic. Some are quantitatively bent. Some keep seeing details but not the big picture. So, know yourself first. If not, your loss will get worse.


3. The investment universe

There are 2 main ways to categorize investments:
  • By asset class - cash, stocks, bonds.
  • By investing style or school - technical vs fundamental, active vs passive.

As you can see, there are a few hundred possible combinations of asset classes and investing styles. Value investing in stocks is one of them. 

How do you start if you want to learn to invest?
  • First, get an overview of the various types of investments as well as the different investing styles.  Sites like Investopedia, Morningstar, or The Motley Fool have good descriptions of the various types of investments as well as the various styles.
  • Then choose one path based on your interest, risk tolerance, and other demographics.
  • Thereafter get an in-depth knowledge of the chosen path and master it through case studies and paper transactions.

If you want more info about the various investment options and how to select an investment approach, refer to the  article: “Baby Steps into the Investment Universe: Beginners: Part 1 of 3

3.1. What's the difference between asset management and portfolio management?

Personally, I think it is the fund management industry way to confuse their clients - they are about spreading your money between various investments

I suspect portfolio is generally used to describe allocating your money amount to different items within the same asset class eg different stocks in your equity portfolio.

Asset management is about allocating your money between different assets eg stocks, bond,

Like I said it is like saying ping pong or table tennis. Asset management and portfolio management both refer to the same thing ie how to spread your money.

Wait till you come to strategic vs tactical asset management, dynamic portfolio management, etc. You are spending time worrying about the same thing.

3.2. If you will be given the chance to have money for investment, would you choose the stock market?

The answer will depend on where you are and the time frame.

I did a study recently that showed that if you are in Malaysia you are better off investing in real estate than the stock market if you have 30yr investment horizon.

Search “In Malaysia which has better returns stock market or property”.  But I have seen reports for the US and Europe where the opposite is true.

So, I have half of my investment in properties and a half in the stock market. You will do differently if you are in the US.

3.3. Is it good to invest in a small-cap that moves 10 to 20% in a day or a large-cap which barely moves even 5%?

People forget that most retail investors would be lucky to achieve the index return year in year out.  So, do not be mesmerized by the quantum of daily movements. It may mean more losses. The challenge is getting consistent returns over decades in order to make money from investing

There are several ways to select stocks
  • Based on popularity. This is a market sentiments-driven approach where you chase those stocks that everyone is chasing as you believe that this will drive prices. Many people use charts and technical indicators to help them gauge what the crowd is thinking.
  • Based on fundamentals. You look for opportunities where the price is less than the value of the underlying business as determined by its fundamentals. You believe that price will eventually reflect the business value.
  • Factor investing where you select stocks based on certain characteristics eg momentum, value, size, etc that supposedly explain the difference in returns.

If you follow the former, you probably are interested in daily price movements. But then you are confusing the price movement with the real basis. The real basis is market sentiments and success comes from the ability to read crowd behavior. Price movement is one proxy. The same applies to size. Are these really good proxies to enable you to forecast crowd behavior?

Secondly, the people who worry about whether it should be large-cap or small-cap are the factor investing guys. But if you follow factor investing you invest long term where “daily price movement” is captured by the momentum factor. It is not exactly the volatility. 


4. Investing in the stock market

The main reason why you would choose stocks over other assets is that it generally delivers the best return over a long holding period. 
  • “…they provide the highest potential returns. And over the long term, no other type of investments tends to perform better.” Morningstar
  • “.. the possibility to increase the value of the principal amount invested. This comes in the form of capital gains and dividends.”  BlackRock

There are also other advantages and disadvantages as summarized in the table.

Pros in investing in Stocks

Cons in investing in Stocks

Earn high returns

The market can be volatile

Good liquidity

The market can crash and you lose a lot

Flexibility in creating a portfolio

Time and knowledge for research

An ownership stake in a company

Returns not guaranteed

Can start with little money

Returns take time

Inflation protection

 

Income from dividend

 


4.1. I’ve been buying shares for 15 years but never sold them. Is that a bad strategy?

Conceptually there are 2 ways to make money from your stock investment:
  • Invest in the “forever” best stocks. These are stocks that will continue to be the best stocks in terms of growth and value creation for shareholders. If you find such stocks there is no need to sell them as their value and prices will continue to go up.
  • Invest in undervalued stocks and when they become overvalued you sell them and reinvest the money into other undervalued stocks.

Given the Kodak and Nokia of the world, I am not sure whether there are “forever” best stocks. Even Warren Buffett who professed to hold onto stocks forever also sells some of his stocks. Have you checked to see what the stocks you hold are still the best today?

I don’t have the ability to identify the “forever” stocks so I follow the latter approach. It works as long as you reinvest the money from the sale into other undervalued stocks. Conceptually your investment fund increases in size each time you sell and reinvest. That is how you grow your investment fund.

4.2. Are there any situations where panic is the correct response in the stock market?

There are 5 ways to invest:
  • Buy and sell pieces of paper. This is a market sentiments-driven approach where you chase the popular stocks.
  • Buy and sell part ownership of businesses. You look for opportunities where the price is less than the value of the underlying business as determined by its fundamentals. You believe that price will eventually reflect the business value.
  • Factor investing. Here you buy stocks based on certain characteristics eg momentum, value, etc that have been proven to explain the price performance of stocks.
  • Indexing. If you don't have the skills to invest based on the above approaches, you should index.
  • Invest blindly. Here you rely on tips, luck to make money.

If you invest following the first or last approaches panic should be an appropriate response.

4.3. Which penny stocks will become stronger stocks in 2021?

Stocks become penny stocks because investors dumped them due to perceived poor prospects. So for these penny stocks to become stronger it must be because:
  • The business fundamentals have improved or show signs of improvement so that they will eventually get re-rated.
  • The business fundamentals were never bad in the first place. It was just that investors over-reacted and dumped the stocks due to herding.
  • Some scammer is pushing the price up hoping for some unsuspecting victim to rush in to buy. The scammer will then sell and leave you bearing the losses.
  • Gamblers like to bet on penny stocks because it is so cheap that if they strike the “lottery” they will make some money.

If you are a gambler, by all means, buy penny stocks blindly.  But if you are a bit more serious type of investor, you better have a defensible reason why you think the stock price will go up.

4.4. Do you lose money if a company does a reverse split?

Imagine $ 100.  This can be one note of $100 or two notes of $ 50.   Is there a difference in value if you have one $100 note or two $ 50 notes?

This is the concept of stock split or reverse split/consolidation.

The intrinsic value of the company remains the same pre-split and post-split although the face value/price of the stock script changes.
  • As a shareholder before the split, you owned one share with $X per share intrinsic value.
  • After the split eg into 2, you own two shares with $ x/2 per share intrinsic value.
  • Your investment intrinsic value is unchanged at $X per share.

However, the stock market is sentiment-driven. Sometimes if a share price is very high, not many would be able to buy. So, companies do a stock split to make it more affordable. Because of this, more people may buy driving the price up. So, while the intrinsic value remains unchanged, the share price goes up.

There is an equivalent story for reverse split/consolidation. The stocks may be penny stocks but by consolidating, it is no longer penny stocks. With this stigma removed, some may buy. Again, this is market sentiment driving the stock price. The intrinsic value remains the same.

If you are a value investor, you look at intrinsic values so you should not be bothered by splits or consolidation. However, you should take advantage that if the exercise causes the price to exceed your intrinsic value, this is an opportunity to make some money.

Will stock splits and/or consolidation cause the market price to drop? Since price is sentiment-driven, there is no reason why it cannot happen.

But the likelihood is that companies undertake the split and/or consolidation to drive the price higher and not lower. I can't imagine any investment bank advising a company to undertake the exercise to reduce the stock price.

4.5. Do you know of anybody who has lost everything in the stock market?

I am very sure that if you talk to a group of people who have engaged with the stock market, you will find that everyone would have lost some money at some point in time.

The likelihood is that half of the group would probably have got richer at the expense of the other half.

But human nature is such that if you ask the group whether they have lost money, and you ask in public, you will find that almost everyone will say they made money.

Do I know of anyone who has lost everything in the stock market?

The likelihood is that you won’t find retail investors among this group as I don’t think any retail investor would have bet all their savings in the stock market.

But do I know of owners of listed companies who have lost everything in the stock market? Yes, because owners tend to have all their net worth invested in the company they founded.

In the Asian economic crisis, there were many Malaysian owners who lost everything. This is partly because they borrow money using their shares as collateral and when the market fell, they started to buy more shares to support the share price so that the banks would ask for more collateral. This worked in “normal times” but in a widespread economic crisis, the market fell longer than the owners could have the cash to support the share prices. The end result is that many lost everything when the banks forced-sold the shares (when the borrowers could not come up with more collateral)

The moral of the story - the people who lost everything are the owners who borrowed. Those who did not have any debt survived and got over the crisis. So, don’t borrow to invest

Retail investors lost some money but I have not heard of any retail investor losing all. So, asset allocation is important even if you don’t borrow to invest.

4.6. How can we use statistics in the stock market?

A stock market is a place where people buy and sell pieces of paper representing part ownership of businesses. As such there are 2 main ways to engage with the stock market.
  • Buy and sell pieces of paper. Here you focus on market sentiments as the driver of price changes. You generally use price and transaction volume data as proxies of market sentiments.
  • Buy and sell part ownership of businesses. Here you buy if the market price is less than your estimate of the fundamental value of the company. Your focus is on the business prospects

There are many statistical techniques used in the former to help gauge market sentiments. You are trying to assess human behavior using statistics. Whether you can make money from such analysis will depend on whether you think human behavior can be so easily predicted.

If you invest following the latter, statistics will not help as you are trying to see how the business will perform in 10 years or more.

If it was so simple to use quantitative techniques to invest in the stock market, lots of statisticians would be millionaires.

Of course, Renaissance Tech and a few other quants have shown that it can be done. But they are not individual retail investors.

4.7. What is the point in owning stocks that don't pay dividends?

Theoretically, the intrinsic value of a company is the present value of the free cash flow generated over its life.

Free cash flow is the amount available for shareholders from profits after deducting the investment required to grow the business.  It assumes that the free cash flow is available to the shareholders

If the free cash flow is all retained, it would increase the assets (usually cash) of the company. Unfortunately, the cash return is much smaller than the operating return. So retaining lots of cash would reduce the overall return.

If the company doesn't pay dividends because all the profits are reinvested ie no free cash flow, it can be a good thing if this is not a long-term feature. You buy cos of potential future returns.

If the company with high free cash flow doesn't pay dividends for no good reason, you would worry about investing in the stock.

If a company doesn't pay dividends because it doesn't have profits, avoid it.



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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.


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