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There are two sections here. One is the Investment
101, which discusses the fundamental concepts of investment, such as
margin of safety, risk and reward, market efficiency, a few words for foreign
investors, etc. The other is Common Sense in Investment and Risk Management,
which covers common sense practices that can enable financial success in the
long run.
Investment
101
Basics
1.
Investment starts from saving. One cent saved is one cent earned.
2. A dollar now is worth
more than a dollar in the future.
3. Market fluctuates all
the time. One can lose money in any stock, one can make money
in any stock. It is extremely hard to time the market and profit by
frequent trading.
4. Money follows
earning. Market is forward looking. Stock rallies most frequent when it
beats Street estimate and the management offers a convincingly bright
outlook.
5.
Execution deserves careful attention. Many things, such as "keep winners
run and cut losers short", are easy said than done. But one should try to
establish good habits, such as
doing detailed fundamental analysis before committing an investment, investing
into companies one understands, and remembering to check technical charts before
buying and selling. Selling puts and selling covered calls can sometimes enhance
performance too. These habits can frequently make a difference as to beat the
market or not.
Risk
and Reward
Risk
and reward are usually correlated in a positive fashion. For example, saving in
a bank is less risky than investing in stocks, but historically the bank rate of
return was also less than the return on stock indexes. Investors normally demand
higher return for taking higher risks. This risk and reward relationship is
reflected in the famous Capital Asset Pricing Model (CAPM), which states that
the expected return is proportional to the risk.
According
to Warren Buffet, however, the opposite is true with value investing. "If
you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill
for 40 cents, but the expectation of reward is greater in the latter case. The
greater the potential for reward in the value portfolio, the less risk there
is."
Margin
of Safety
Under
normal conditions, the margin of safety for investment in stocks lies in an
expected return considerably above the going rate for bonds. The margin of
safety is always dependent on the price paid. It is large at one price, small at
some higher price, nonexistent at some still higher price.
If
a business is worth a dollar, and I can buy it for 40 cents, I believe something
good may happen to me.
"The
risk of paying too high a price for good-quality stock -while a real one-is not
the chief hazard confronting the average buyers of securities. Observations over
many years has taught us that the chief losses to investors come from the
purchase of low-quality securities at times of favorable business conditions.
The purchasers view the current good earnings equivalent to "earning
power" and assume that prosperity is synonymous with safety. Common stocks
of obscure companies can be floated at prices far above the tangible investment,
on the strength of two or three years of excellent growth. These securities do
not offer an adequate margin of safety in any admissible sense of the
term….Most of the fair-weather investments, acquired at fair-weather prices,
are destined to suffer disturbing price declines when the horizon clouds
over-and often sooner than that. Nor can the investor count with confidence on
an eventual recovery-although this does come about in some proportion of
cases." Benjamin Graham
Diversification
When
all risks are firm specific, diversification can reduce risk to arbitrarily low
levels. In this case, the risk sources are independent, and with the portfolio
spread across many securities, the exposure to any particular source of risk is
negligible. However, when common sources of risks affects all firms, even
extensive diversification cannot eliminate the risks. The risk that remains even
after extensive diversification is called market risk, risk that attributable to
market wide risk sources. Such risk is also called systematic risk, or
non-diversifiable risk. In contrast, the risk that can be eliminated by
diversification is called firm-specific risk, or nonsystematic risk.
Even
with a margin of safety in the investor’s favor, an individual security may
work out badly. For the margin guarantees only that he has a better chance for
profit than for loss—not that loss is impossible. But as the number of such
commitments is increased the more certain does it become that the aggregate of
the profits will exceed the aggregate of the losses.
Technical
Analysis
Technical
analysis is essentially the search for recurrent and predictable patterns in
stock prices. Technical analysts are sometimes called technicians or chartists,
because they study records or charts of past stock prices and volumes, trying to
find patterns that can be exploited for a profit. Once a useful pattern or
technical rule is discovered, however, it tends to self-destructing once the
mass of traders attempt to exploit it. The market dynamic is thus one of
continual search for profitable trading rules followed by destruction because of
overuse of those rules found to be useful, followed by more search for
yet-undiscovered rules.
Fundamental
Analysis
Fundamental
analysis uses earnings and dividends or free cash flow prospects of the firm, expectation of
future interest rates, and risk evaluation of the firm to determine proper value
of the firm. If that value exceeds the stock price, the fundamental analyst
would recommend buying the stock. The analysis usually starts with a study of
past earnings and an examination of company balance sheets. It is further
supplemented with detailed economic analysis, an evaluation of the firm’s
management and strategy, the firm’s standing within its industry, and the
prospect of the industry as a whole (including the size of the potential market
and the growth rate). The hope is to attain insight into future
performance of the firm that is not yet recognized by the rest of the market.
Market Efficiency
Background:
In 1953, Maurice Kendall published a paper on the analysis of stock prices over
time, with a surprising finding that he could identify no predictable patterns
in stock prices. Prices seemed to evolve randomly. They were as likely to go up
as they were to go down on any particular day, regardless of past performance.
Past price data provided no way to predict future price movement.
At
first flush, Kendall’s results were disturbing to some financial economists.
The results seemed to imply that the stock market is dominated by erratic market
psychology, or "animal spirits" - that follows no logical rules. In
short, the results appeared to confirm the irrationality of the market. On
further thinking, however, economists came to reverse their interpretation of
Kendall’s study. Random price movements indicated a well-functioning or
efficient market, not an irrational one. Suppose that the price movement is
predictable with certainty using a "Kendall’s Equation", and company
ABC’s stock is predicted to increase drastically to $120 three days later from
$100 today. Obviously, people will place buy orders immediately to cash in the
perspective price increase. No one holding ABC, however, would be willing to
sell. The net effect would be an immediate jump in stock price to $120. The
prediction with certainty a future price change will lead instead to an
immediate price change.
The
Efficient Market Hypothesis asserts that the stock price movement is not
predictable with certainty. Stock prices reflect all currently available
information, and change only to respond to new information. However, there are
three versions of the hypothesis depending on what is meant by the term
"all available information."
The
weak form hypothesis asserts that stock prices already reflect all information
that can be derived from examining market trading data such as the history of
past prices, trading volume, or short interests. This version of the hypothesis
implies that trend analysis (technical analysis) is fruitless. Past stock price
data are publicly available and obtainable virtually at no cost. If such data
ever conveyed reliable signals about future performance, all investors would
have already learned to exploit the signals. Ultimately, the signals lose their
value as they become widely known because a buy signal, for instance, would
result in an immediate price increase.
The
semistrong form hypothesis states that all publicly available information
regarding the prospects of a firm must be reflected already in stock price. Such
information includes, in addition to past prices, fundamental data on the
firm’s product line, quality of management, balance sheet composition, patents
held, earning forecasts, earning surprise history, and accounting practices.
Again, if any investor has access to such information from publicly available
sources, one would expect it to be reflected in stock prices. This version of
the hypothesis implies that most fundamental analysis is doomed to failure. This
is partly confirmed by the many downgrades numerous companies received after
one earning disappointment. If the analysts relies on publicly available
earnings and industry information, his or her evaluation of the firm’s
prospect is not likely to be significantly more accurate than those of rival
analysts. Only analysts with a unique insight will be rewarded.
The
strong form version of the efficient market hypothesis is quite extreme, and few
people believe its soundness. It states that stock prices reflect all
information relevant to the firm, even including information available only to
company insiders.
The
following are some quotes from experts:
"I
am convinced that there is much inefficiency in the market. When the price of
stock can be influenced by a "herd" on Wall Street......, it is hard
to argue that the market always price rationally. In fact, market prices are
frequently nonsensical. Value investors have successfully exploited gaps between
price and value." Warren Buffet
"Market
valuations rest on both logical and psychological factors. The theory of
valuation depends on projection of a long term stream of dividends or free cash
flows whose growth rate is extraordinarily difficult to estimate, and subject to
change with ever changing economic, technological, and competitive situations.
Thus, fundamental value is never a definite number. It is a fuzzy band of
possible values, and stock prices can move sharply within this band whenever
there is increased uncertainty or confusion. Moreover, the appropriate risk
premiums for common stocks are changeable and far from obvious either to
investors or to economists. Thus, there is room for the hopes, fears, and
favorite fashions of market participants to play a role in the valuation
process. History has provided extraordinary examples of markets in which
psychology seemed to dominate the pricing process, as in the tulip-bulb mania in
seventeenth-century Holland and the Japanese stock boom of the late 1980s
followed by the crash of the early 1990s.
Information
contained in past prices or any publicly available fundamental information is
rapidly assimilated into market prices. Prices adjust so well to reflect all
important information that a randomly selected and passively managed portfolio
of stocks perform as well as or better than the portfolios selected by experts.
If some degree of mispricing exists, it does not persist for long. "True
value will be out" in the stock market. Moreover, whatever mispricing there
is, it is usually only recognizable after the fact." Burton G. Malkiel, A
Random Walk Down Wall Street.
In
summary, it is fair to say the stock market is quite efficient, but
non-efficiency still occurs.
Small
Cap Mystery
One
of the most important anomalies with respect to the efficient market hypothesis
is the small firm effect, originally documented by Rolf Banz, that both total
and risk-adjusted rates of return tend to be bigger for firms with smaller
market capitalization. Later Donald Keim and many others further documented that
small firms outperform big firms in all months except October, and the
out-performance was biggest in January. The reasons for this empirical
result include tax loss selling, neglected-firm effect, and liquidity
effect. Avner Arbel and Paul J. Strebel, in a paper titled "Pay
Attention to Neglected Firms," found that information about smaller firms
is less available because small firms tend to be neglected by large
institutional traders. This information deficiency makes smaller firms riskier
investments that command higher returns. Yakov Amihud and Haim Mendelson argued
that investors generally demand a higher rate of return to invest in less liquid
stocks.
For Foreign Investors
For
foreign investors, it is important to understand American people. The following
two points may deserve some further thinking:
American
is a country that rewards excellence and punishes under performance. This is
reflected in stock prices. Companies that beat estimates and provide good
earning visibility get richly rewarded. Their P/E, P/sales, and P/BV ratios are
high and expanding. This is witnessed by the run up of MSFT, DELL, CSCO, LU,
AOL, YHOO during the boom years (late 1990s). Companies that miss estimate get severely
punished or even slaughtered. There are numerous examples of this kind. These
stocks did not participate much in the upside, but participate in the downside.
American
is a country that rewards aggressiveness. As an example, AOL’s studio, an idea
that pumped its stock price in the past, didn’t seem to work. The company then
decided to reorganize in Spring 1998, and took an $80 M charge. The financial
market seems very forgiving. Its stock price kept rising.
Common Sense in Investment and Risk Management
1.
Keep liquid liquid unless you are quite sure of a profit. Since it is very hard
to time the market and sell the stocks for a profit, it’s wise to set aside in cash
a few months’ living
expenses as an emergency fund that may be needed in unexpected events
(illness, unemployment,
etc.). To avoid unnecessary loss, don’t use any money to buy
stocks if that money is needed in a short time.
2.
Start early. The greatest asset any investor can have is time. The sooner you
start, the sooner you’ll get the learning and experience, and the sooner
you’ll be able to make compound growth work for you.
3.
Commit yourself to regular investing. A good way for regular investing is to
take advantage of employer-sponsored retirement plans and IRAs to invest at
each pay day, which will reduce current year taxes and will buy
more shares in down days with the same amount of money, the benefit of so-called
"dollar cost averaging".
4.
Allocate money among asset classes (stocks, bonds
and cash equivalents) and within each class (industry sectors and geographic
regions). Such diversification can spread risk over a variety of
investments, reduce volatility, and
provide more consistent and reliable financial returns. Though more volatile
than other investments in any given year, stocks historically have
outperformed all other types
of investments while staying ahead of inflation in most longer time periods. Bonds and cash
equivalents, on the other hand, provide excellent protection in a down
market. Generally speaking (based on past history), the more assets
allocated to stocks the
better the long term growth of the portfolio. Keep in mind that the stock market has had a
remarkable run since 1982 when Dow Jones index was less than 800, an
average annual return 16.6%. Many stocks are too overvalued now to
provide such a high
future long-term return.
5.
Invest in index funds (important for average investors). A simple and excellent way is to invest in stocks to buy
a broad-based index fund. Index funds are funds with a core holding of
diversified stocks designed to track the stock market's performance. This passive investment
strategy, though
less exciting, is quite rewarding. Over the last twenty five years, for example,
over 2/3 professional money managers under-perform the SP500 index.
6.
Know yourself. Understand yourself as an investor — your emotions, your fears,
and your tolerance for risk. Find out investments that you are comfortable
with, and styles you
are suited, all of which will take time and experience. Your personal attitude toward risk and
your personality are major factors in investment planning. If you feel
comfortable across a broad spectrum of risk, you may pursue your goals
more aggressively. Some people have quick minds, and enjoy quick
execution. They may be able
to make quick money or cut loss short. If you are uneasy, on the other hand,
steady and slow is the way to go. We recommend highly this defensive approach to
investing. Very
often, a portfolio can be ruined by one or two bad and aggressive investments.
It is always better safe than sorry. In this regard, patience is a virtue.
Maintain the discipline
to sit tight or add to appropriate investments through down markets. Do not
hurry into buying or selling unless you have profound reasons to do so.
Riding out short-term
fluctuations, you’ll come out all fine in a longer term view, and most time will benefit
from potentially higher long-term gains.
7.
Minimize expenses. Over the long run, sales charges, loads and expenses can drag down the
performance of even a well-diversified portfolio. Reduce your investment
expenses by using no-load funds and low-cost trading services. A buy and
hold strategy can
reduce not only the trading costs but also the capital gains taxes for majority
of investors.
8.
Review your portfolio and make adjustment over time. You'll need to evaluate the performance of
your investments against relevant risk-adjusted benchmarks, at least
once a year, and certainly whenever personal circumstances change. The
proportions of
different asset classes comprising your portfolio depend on your goals and
circumstances and the macroeconomic picture - all of which changes over
time. As you move into different stages of your life,
evaluate your investment portfolio's appropriateness and make adjustments
accordingly.
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