There are many financial markets around the world, on which are traded stocks, bonds, currencies, financial and commodity futures and much more. Although the principles of analysis and investment are generally held to be universal, there are important differences, most especially in types and levels of risk. Since my experience is in the stock market, that will be the only focus of this book.
Speculation versus investment
There is a great deal of confusion about terms describing activity in the stock market. This confusion seems to be a large problem when people describe what they do as ātradingā. When that term is used, we will not know what they mean until we ask further questions. What kind of securities does the self-styled trader deal in? Does the traderās market activity involve the risking of capital to harvest many small gains? Or does it involve buying stocks in sound businesses in the expectation of low-risk accumulation of capital while reaping a dividend stream? At these extremes things are fairly clear, but in between there is a large murky area where the two activities are intertwined in many peopleās minds to a greater or lesser extent.
These issues were discussed by Benjamin Graham in his book The Intelligent Investor. I have found that the ambiguity of the term ātradingā can be clarified by falling back on the terms he used: āspeculationā and āinvestmentā. However, this is not a perfect answer. Perhaps there will never be an absolute solution to the issue. It is therefore important that I define exactly what I mean by these terms, so that my use of them in this book is clear.
If I say that I made a successful āspeculationā in a stock, my audience is likely to think that I bought a stock and later sold it for more than I originally paid for it. Or that I sold it short and later bought it back for less than I paid for it. People who buy and sell stocks in this way are essentially risking their capital with the aim of increasing it. Any dividends they receive are almost incidental and rarely mentioned. This activity is most usefully described as speculation.
If I say that I made a successful āinvestmentā in a stock, my audience is more likely to think that I bought a stock that paid me a good dividend stream and increased in value over the time I held it. In other words, I bought part-ownership of a business that was successful over time. People who purchase stocks in this way will be primarily concerned with preservation of capital, while earning an income stream and hopefully seeing their capital grow. This activity is most usefully described as investment. Investment, as I use the term, will not involve short selling.
I have chosen to use the terms speculation and investment rather than trading and investing, to try to clarify things. However, if readers prefer the term trading, that is fine, just substitute it for speculation when I use that term.
The long-term average return from Australian stocks has been about 12 per cent per year. Over the long term, 4 per cent of this return was from dividends and 8 per cent was from capital growth.
These numbers will vary for other markets depending on the methodology used, the time period chosen and the nature of the market. For the US stock market, the total return over the last century has been about 9.6 per cent per year, of which 4.5 per cent was from dividends and 5.1 per cent was from capital growth.
When people hold stocks for more than a few days, weeks or months, their focus is likely to be on the total return from both capital growth and dividends. These people are best described as āinvestorsā.
This book is about investment. While many aspects of it may be usefully applied in speculation, there are important differences between these two activities in the stock market.
Active versus passive investing
When I first set down my investment plan, I wanted to emphasise that my investing method was the very opposite to a passive investment approach. I described this as aggressive investing, because, in general industry usage, that was the opposite of passive investing. In fact, Benjamin Graham used it in that sense in The Intelligent Investor, so it had an excellent pedigree. However, rather too many people exist outside the industry as private investors and so were picking up another general use in everyday life which meant that I had an aggressive temperament as a person. Instead, I had used the term as meaning that I used an investment style that was the opposite of passive. I am therefore going to refer to my investment plan as being an āactiveā approach.
In my active investing method, I am seeking to be fully invested in stocks through most of a bull market and to be fully invested in cash through most of a bear market. This is called āmarket timingā, and is not easy to do. I will explain in a later chapter what is involved and how long it will take most people to become proficient at this.
Active investing is usually castigated by professional fund managers. Their argument is that, if investors are out of the market on the 10 best days of a bull market, their long-term return is seriously damaged. However, these fund managers are talking their book: they want investors to leave their money in the fund long term.
What they say is true as far as it goes. However, a momentās thought will suggest that if we are out of the market on the 10 worst days of a bear market, our long-term return will be significantly better.
What I am attempting to do as an active investor is to be in the market when it is rising and out when it is falling. As we will see later, that can work very well.
This does not mean that passive investing, which is called ātime in the marketā in industry jargon, is an inferior approach. For one thing, it is much easier to do than active investing. While it still demands investment knowledge and skills, it is a generally safer approach. This is because, if it is properly carried out, passive investing is strongly focused on preservation of capital in the selection of stocks for a portfolio. The long-term upward bias in stock markets also works in favour of passive investors, because stocks in good businesses will tend to rise again after a cyclical fall.
Active investing is also strongly focused on preservation of capital. However, the timing aspect means that in order to pursue greater capital growth and strong dividends, many more decisions must be made. This means that there is also more opportunity to make bad decisions.
Of course, taxation is an overwhelming consideration for many private investors. This may bias many of them towards the passive approach to investment. Then again, focus on taxation also leads passive investors to make poor decisions sometimes, such that minimising tax means capital is lost. It always tends to cut both ways.
My approach to the taxation issue is simple. Start with the proposition that investing is a business. We are in it to make a return on our capital. If we did that by owning a whole company, we would know we have to pay tax on our profits. Is this any different if we are only part-owners by buying shares in the company?
So, my suggestion is to set up our affairs in the lowest tax environment that is legally and economically available to us. Then set out to maximise our investment return. No matter what rate of tax we end up paying, a tax bill of a million dollars is always better than a tax bill of half a million dollars because it means we made more profit.
Analysis versus investing
Professional funds management companies employ people to analyse stocks or the market. They employ other people to make the investments and to manage the portfolio. Successful private investors will generally be carrying out both functions, so they will require two different types of skills:
ā¢ The formation of an opinion about the market or about a stock. We call this āanalysisā.
ā¢ The execution of buying and selling strategies, including money management. We call this āinvestingā.
The skills of analysis and investing are different and many find it difficult to be good at both activities. One reason for this is that the two processes have quite different objectives:
ā¢ Analysis is trying to get each view about the market or a stock correct. With their reputation at stake on each recommendation, analysts will be trying to get every recommendation right. This book will use some analysis techniques, but only as a means to an end, which is investing.
ā¢ Investing is trying to make a net return from available capital. The return from each individual stock is not of critical importance. Rather, the investorās focus is on the net return on the capital over a period.
I regard myself as an investor first of all and an analyst as a distant second, even though I have spent a great deal of time learning a lot about analysis. The whole focus of this book is on investing.
Analysis tends to attract people who lean towards being perfection-ists, who like to unravel mysteries or solve puzzles and who have great patience in collecting, analysing and synthesising information. Good analysts learn a great number of techniques. They know how to apply them to different situations, trying always to fit the tool to the task. They tend not to form views on the market lightly and tend to hold to them strongly once formed. They dislike being wrong. They gravitate to complex and intricate analysis processes.
Investors take analysis as a starting point for making their investment decisions. They have a strong focus on results and work hard on their decision-making skills. Good investors tend to have a few models with a high probability of success. If a situation does not fit one of the models, investors can simply pass it up. Compare this to analysts, who may be required to analyse any situation. Investors like putting strategies and tactics into effect and playing the game by adjusting tactics as necessary to win. They accept that each foray into the market will not necessarily be successful. Instead, they are concerned about their net results at the end of the investment period. They are comfortable changing their opinion quickly and as often as the market proves them wrong. They tend to use simple but robust decision processes.
It is not surprising that some people make good analysts and poor investors. Others make good investors, but poor analysts. This is why a large institution will look for different people to perform analyst and portfolio manager roles. The skills of the different personality types are put to work in the roles for which they are most suited.
However, the private investor does not generally have this luxury and must carry out both roles. It is therefore important for private investors to understand which personality type they tend towards. They should then try to make the necessary conscious adjustments in habitual behaviours and to adopt methods that help overcome natural biases.
It is especially important that the private investor realise that analysis is only one part of the investment process and not necessarily the most vital part. Private investors who have a penchant for the analysis role, and who seek to also take on the investing role, will face a problem. They are going to have to discipline themselves to simplify the analysis and work consciously on the portfolio management problems. Their focus here should be primarily on strict money management and the psychology of the investing decision-making process. Having a sound investment plan is an essential way to achieve this.
Fundamental versus technical analysis
Analysis of stocks is often divided into two broad disciplines, known as fundamental analysis and technical analysis. Both have the same objective, which is to form an opinion about a market or a stock. They simply approach the problem from a different perspective.
Fundamental analysis approaches the problem by attempting to estimate the intrinsic value of a company. If we then divide the intrinsic value of the company by the number of stock units that the company has issued, we have the intrinsic value of each stock. Conventional wisdom indicates that the price of a stock that is selling for less than its intrinsic value should rise, whereas the price of a stock that is selling for more than its intrinsic value should fall.
Intrinsic value is estimated with reference to the factors that should affect the future earnings of a company: sales, margins, capital structure, management, competition, industry outlook, government policy and economic outlook, to name a few. The fundamental analyst thus studies the factors that affect prices, or changes in prices, of stocks.
A problem with fundamental analysis is that it assumes that information is disseminated perfectly and that it is acted on rationally, rather than emotionally. Practical observation of markets suggests that these assumptions do not necessarily hold in the real world, particularly in the short term. However, it is generally accepted that prices will move as indicated by intrinsic value over the longer term.
Many private investors are put off by fundamental analysis. Why is this? Is it because it does not work? It cannot be that, because it is the mainstream method used by most professional analysts. It has been used by most of the stock market investors who have superior long-term results since Benjamin Graham invented security analysis as a discipline in the 1930s. So, we know it does work. There is very persuasive evidence that prices reflect earnings in the medium to long term.
Perhaps it is because it is difficult to do. This is more likely. Fundamental analysis requires a basic understanding of the dynamics of a business and how those dynamics are reflected in the accounting statements. There is nothing intellectually difficult about it. However, most people see a financial statement and their eyes begin to glaze over.
Need fundamental anal...