How to Develop Your Approach to Stock Market Investing

December 13, 2013

NYSE

 

How To Develop Your Approach To Stock Market Investing

As noted in our first lesson, Investing 101, stocks represent fractional ownership stakes in businesses. Also in that lesson, we outlined some commonly used financial measures as a basis for beginning to understand stock analysis. I will go over those in more depth in a later lesson. In this lesson, I want to help you understand what I believe is the right way to approach stock investing, from a philosophical perspective, as well as a practical perspective. Your investing philosophy matters very much. You really need to have a good handle on what it means to be a responsible and wise stock market investor before digging into the details of individual stocks.

That’s because there is a lot of advice and instruction that you need to learn to ignore from the outset. Peter Lynch says, “One of the biggest troubles with stock market advice is that good or bad, it sticks in your brain.” There is no shortage of methods, theories, strategies, etc. which purport to help individuals achieve above average returns. However, the most important key to success is developing the right approach to stock investing, and whether you stick with that approach through all of the ups and downs of the market.

Thus, individuals who are successful stock investors tend do a few things well:

1)  Buy stocks with a very long term view, and a plan to hold those stocks through ups and downs. Buying index funds is easy. Just set it and forget it. If they are buying individual stocks, they should continue to hold as long as the fundamentals of each specific company are still sound. The best examples of a reason to sell a stock because of deteriorating fundamentals would’ve been if you were still holding Blockbuster when you first used Netflix, or if you were holding Eastman Kodak (primarily a film company) when you saw your first digital camera or photo quality printer. We will have an entire separate lesson on when to sell a stock.

2)  Focus on fundamental analysis. Fundamental analysis refers to the use of information such as valuation measures of a stock, business results of the company, accounting and financial statement information, business strategy, competitive advantages of companies, weaknesses, opportunities, threats, various risks, industry dynamics, demographics, consumer trends, and corporate governance issues (how well company board/managers distribute benefits among stakeholders). This is different from technical analysis, which is briefly mentioned below. Fundamental analysis is based on time tested wisdom. Further, it should be intuitive (common sense) to most people how and why this approach can be expected to work.

3)  Avoid outright attempts at market timing. Instead, successful investors tend to buy through making regular contributions toward investments. This means they set aside and put to work a certain amount of money each month toward investments, regardless of overall market levels and valuations, economic measures, etc. They invest in up markets and down markets, because they realize that they can’t predict the future in the short run, but that the long term trend of stock prices is to rise significantly. Further, if you invest in dividend paying stocks, you will always be getting some level of return on your original investment. The reason my wording says avoid outright attempts at market timing is because you may very well, at rare times, employ fundamental analysis and find that no stocks are worth buying. There are times when valuations as a whole get completely detached from reality. In those times, it may be difficult for you to find stocks that are worth buying, in light of sound fundamental analysis. Now, in regard to market timing, I am speaking to people who are in their working years, sticking to a financial plan that will allow them to reach their goals. If you are independently wealthy and have already reached your financial goals and way beyond, no one will begrudge you the pleasure of sitting on cash or short term bonds until the market is down 20-40% (or more accurately, waiting until the Shiller PE is below 12) from its most recent highs before you decide you have any sort of interest in the stock market. But if you have goals to achieve, you run the risk of not achieving them by waiting on a day that may never come. I will talk more about market timing in the future. For now, please just trust me that you shouldn’t set out to do it. It’s too much of a gamble with your future.

Technical analysis is very different from fundamental analysis. It is an attempt to determine the direction and level of future movements of a stock price based on the recent trading history of a stock. To me, it is the equivalent of trying to understand the path of the wind. I ignore it completely.

Let me further say, that any strategy based on a short term view of potential price movements of any “investment” is akin to a get rich quick scheme. In my opinion, such strategies really have no place among Christian investors. Trying to correctly time short term movements in prices or other market variables isn’t much different from betting on a football game, in my opinion. Biblically speaking, looking for quick profits is ill-advised. Like Peter Lynch says, "Many small investors are dissatisfied with getting rich slow. Instead, they opt for getting poor quick."

Ecclesiastes 11:1 says, “Send your grain across the seas, and in time, profits will flow back to you.” (NLT – emphasis added)

Sending your grain across the seas sounds like a long term investment to me. No quick riches there, but also no guarantees. Investing normally involves entrusting our assets to the care of someone else, just like it did for Solomon when he sent his grain across the seas. The Bible is clear that uncertainty will always remain, but that we should not act out of fear. If you have not yet downloaded and read our free report What Every Christian Investor Needs to Know, you need to do that. If you’re a Christian, you really should be starting out by getting a very good handle on what the Bible says about investing. Why do you care what I have to say about a topic if you don’t already know what the Bible says?

One question I have been asked by readers is “What is a reasonable expectation of return for stock market investing?”

The relevant market average annual return from 1928 – 2012 was 9.31%. The relevant market average is known as the geometric average, and sometimes referred to as a Compound Annual Growth Rate (CAGR for short). Since I have been following the stock market (about 12 years), that number has generally fluctuated between 9-10%. So, the long term average is fairly steady. What’s not steady, are actual annual returns:

Year S&P 500
1928 43.81%
1929 -8.30%
1930 -25.12%
1931 -43.84%
1932 -8.64%
1933 49.98%
1934 -1.19%
1935 46.74%
1936 31.94%
1937 -35.34%
1938 29.28%
1939 -1.10%
1940 -10.67%
1941 -12.77%
1942 19.17%
1943 25.06%
1944 19.03%
1945 35.82%
1946 -8.43%
1947 5.20%
1948 5.70%
1949 18.30%
1950 30.81%
1951 23.68%
1952 18.15%
1953 -1.21%
1954 52.56%
1955 32.60%
1956 7.44%
1957 -10.46%
1958 43.72%
1959 12.06%
1960 0.34%
1961 26.64%
1962 -8.81%
1963 22.61%
1964 16.42%
1965 12.40%
1966 -9.97%
1967 23.80%
1968 10.81%
1969 -8.24%
1970 3.56%
1971 14.22%
1972 18.76%
1973 -14.31%
1974 -25.90%
1975 37.00%
1976 23.83%
1977 -6.98%
1978 6.51%
1979 18.52%
1980 31.74%
1981 -4.70%
1982 20.42%
1983 22.34%
1984 6.15%
1985 31.24%
1986 18.49%
1987 5.81%
1988 16.54%
1989 31.48%
1990 -3.06%
1991 30.23%
1992 7.49%
1993 9.97%
1994 1.33%
1995 37.20%
1996 22.68%
1997 33.10%
1998 28.34%
1999 20.89%
2000 -9.03%
2001 -11.85%
2002 -21.97%
2003 28.36%
2004 10.74%
2005 4.83%
2006 15.61%
2007 5.48%
2008 -36.55%
2009 25.94%
2010 14.82%
2011 2.07%
2012 15.83%

 

Source: NYU

Take a look at the returns from the table above. Go all the way back to the 1928 return and look through each one slowly, all the way up to 2012. Think about how it might feel to watch the market value of your investments fall as much as 40% in a given year. You really need to have an awareness that stock returns never move up in a straight line. There are ups and downs, but stocks pay off very well for investors that buy and hold them through all the ups and downs. It helps if you fully understand the nature of volatility in stock investments, and keep yourself reasonable regarding your expectations, and rational regarding your approach. Primarily, you need the emotional fortitude (i.e. patience and self-control) required to stick with your plan even when things look grim, because your rational mind is armed with knowledge and can still recognize that things normally work out great for stock investors in the long run.

Now, one last point to be made about expenses. Basic math tells us that the average investor over a particular time period will receive the market average return minus the fee and expense rate incurred by their investments. So, if we use past returns as a proxy for future returns, we can expect the market average return of 9.3% per year (as a compound annual growth rate) on our investments. However, we will be paying out some rate of expense associated with our investing activities. If we divide the $100,000 into 30 different stocks, we pay $210 in trade commission when we initially invest. If we hold our stocks and do no trading over the entire period, there are no further fees associated with our investments. The $210 initial trading cost would equate to less than .01% as an annual fee. Now, realistically, there will be some small amount of trading if you were trying to, for example, mimic the DJIA, because there are periodic changes to the index. Alternatively, you could decide to buy and hold the 30 largest stocks in the S&P 500. Either way, the trading commissions remain a negligible amount on a $100,000 portfolio unless you are buying and selling stocks very frequently. For the rest of this example, let’s say the trading costs over time amount to .1% per year (10 times what they would be if we just bought and held the same 30 stocks). Moving on, if we invest in VOO, a Vanguard S&P 500 composite, our annual fee is .05% per year. This causes our expected return to drop to 9.25% per year. If we invest in actively managed mutual funds, and pay the average 1.5% annual expense rate, our expected return drops down to 7.8% per year. If we hire a fee only advisor to sell us those funds, and pay him 1% per year, our expected return drops down to 6.8% per year. If we hire a commission based advisor who gets a 5% load fee up front, then churns our account in order to get new load fees every 5 years (a very conservative estimate), we will end up with a return of 6.52% per year. By the way, churning is what happens when an unscrupulous advisor calls you up to tell you that they have a great new fund or product to replace the fund they previously sold you, which is now stinking up the joint. But to be fair, there are good advisors!

$100,000 compounded over 30 years, at a net rate of return of 9.25% per year, becomes $1,421,161.29

$100,000 compounded over 30 years, at a net rate of return of 9.2% per year, becomes $1,401,777.71

$100,000 compounded over 30 years, at a net rate of return of 7.8% per year, becomes $951,837.53

$100,000 compounded over 30 years, at a net rate of return of 6.8% per year, becomes $719,676.93

$100,000 compounded over 30 years, at a net rate of return of 6.52% per year, becomes $665,173.18

By the way, if you're thinking, "Who the heck has $100,000 to invest when they're 30?" Just realize that this is a simple example to illustrate the power of compounding, and the effect of investment expenses. $100,000 is a nice round number, and is easier to think about than investing $10,000 per year for 30 years. Anyway, the math works such that a 9.25% return turns $10,000 into $142,116.13, so it's easy to apply it to whatever amount you may have at the moment. If you would like to play around with compounding math on your own, here is a calculator for doing so. It includes the ability to input a monthly contribution.

Getting back to our example, the Vanguard fund investor does the best (assuming our direct stock investor traded some along the way instead of buying and holding the same 30 stocks). The person who invests directly into 30 stocks with a mostly passive strategy does second best. The person who invested directly in mutual funds via an online discount broker comes in third. The person who bought through a fee only financial advisor that sold him or her actively managed funds, came in fourth. The person who bought mutual funds via a commission based financial “advisor”, aka a mutual fund salesperson, came in dead last. If a financial advisor or other professional indicates that you can expect 12% average annual returns, you now have the information you need to thoroughly question such an unconscionable claim. After using correct math and subtracting expenses, they are rationally expected to deliver 6-7% per year, based on the average expense numbers I used. Many of them have higher fees and expenses than what I've listed here! Now, keep in mind that this is only an example, based on assumptions about average returns and expenses. Actual results will vary for each individual. More than anything else, it is important that you review what the Bible has to say, and spend some time in earnest prayer before deciding which route to take.

FEES MATTER.

They matter tremendously. No matter what they are called, what form they come in, or how frequently or infrequently the fees are charged, they matter a great deal. There are so many tricks, strategies, philosophies, and approaches to stock investing. But, there is only one surefire way to increase your expected return as an investor: cut the fees and expenses out!  It works!

We ended up outlining five common approaches to long term stock market investing. Despite my clear preference for the first two (at least from a purely financial perspective*), Wisdom's Reward will be adding lessons soon that are designed to help guide readers under any of the approaches they may decide to take. Even for the ones that I find particularly awful, there are still going to be people who are convinced that is the way they want to go. I will do my best to help them out by arming them with as much information as possible. I will probably even seek out a guest writer for the last two, in order to deliver unbiased help. From a practical standpoint, the five approaches were:

1)      Direct stock investing

2)      Index fund investing, via either an index mutual fund, or an index exchange-traded fund

3)      Direct investments in actively managed mutual funds, via an online discount brokerage

4)      Using a fee only financial advisor

5)      Using a commission based financial advisor

Stay tuned!

 

* I wanted to note here that to my knowledge, at least as of 12/13/2013, indexing ignores any desire on the part of the individual to morally screen their investments. That is to say, I don't know of any passive, morally screened index products. I will be researching more and covering all of this in more detail in my lesson on index fund investing.

 

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At the time of publication, the author does not hold any positions in any of the securities mentioned and has no plans to initiate positions in those securities within the next 72 hours. The views expressed are the opinions of the author and do not necessarily reflect those of Wisdom’s Reward, LLC.

  • Leo S

    Chris, this is a very helpful second article in your Education series. I had a few follow-up questions that I wonder if you might give your perspective on:
    1) Fundamental Analysis makes use of data that any investor can freely get access to. Is it really possible to find an ‘edge’ with this data? Surely all the big movers and players have already found the good opportunities by the time I stumble upon one. I am not so much challenging, but wondering if I have a misunderstanding or assumption about the market.

    2) I see people write that owning stock is like owning a piece of the company. This is true but usually doesn’t a company only issue stock so that they still retain control of the company? And buying stock seems to only make me indirectly participate in the success of the company. It seems like the money to be made with stocks is when I eventually sell them to another investor. I don’t get any of the profits of the company do I?

    3) With respect to making money when I sell the stock at a higher price to another investor and make a profit—the profit I make in the market is from another investor. If I think I’m selling the stock because it is not a good idea to hold it any more—maybe something in the fundamental analysis has changed—the investor(s) buying from me are presumably buying in ignorance. Should I feel any moral qualms about profiting at the ignorance of others?

    Thanks for such a great site. You have so clearly dedicated this site to God and honoring him with thanksgiving! I wish you success as you try to bless others with your skill set!

    • WisdomsReward

      Leo,

      Thank you very much for your interest, kind words, and feedback on my site. I love to see how you are thinking philosophically about stocks. It helps to develop that kind of understanding. Here are my answers:

      1) Data and information are all freely available. However, not everyone uses the information. There are a million different reasons why individuals buy and sell stocks. But that doesn’t invalidate your point because large investors should be able to quickly take advantage of any discrepancies caused by irrational market participants. There is an academic theory about this called the Efficient Market Hypothesis. But here is the short answer to your objection… my fundamental analysis may yield a completely different result than yours. It’s all about how to analyze and interpret the information available. 15 analysts can cover one stock, use the same information to perform their analysis, and come up with 15 different conclusions. Further, realize that those analysts are primarily using all of the available information to come up with forecasts of the future. They are generally trying to determine what the sales and profits of a company will be next year, the year after, and the year after that. Some analysts’ forecasts extend beyond 3 years, but most don’t even bother, as it generally proves very difficult to forecast accurately beyond the next few quarters. None of this stuff is an exact science, so you get a lot of variation at times. Finally, realize that you don’t necessarily have to identify “mispriced” stocks in order to make money in the stock market. You can buy companies that are “fairly valued” and expect to get the market average return, adjusted for the level of relative volatility of that specific stock. The market generally carries what’s known as a risk premium (a return that investors require above the risk free rate). That’s why the market average return for stocks is higher than it is for other types of securities. If you really find all of this interesting, you can check out more about the efficient market hypothesis:

      http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

      But realize that it is an academic theory, and many practitioners adamantly deny its conclusions. For example, Warren Buffett, along with many others, attributes his phenomenal market beating success to the use of fundamental analysis. I honestly don’t think it will help you to be a better investor to study efficient market hypothesis, but it may help you decide whether you think it is worthwhile to even try picking individual stocks. I will tell you this, though they aren’t always bountiful, I believe that there are definitely pockets of major inefficiency at times. Sometimes they can last for years. Were internet stocks in the late 1990s trading on rational fundamental analysis? Is Twitter (TWTR) trading in an efficient market, on rational fundamental analysis, when the company goes from being valued at $21 billion to $32 billion within less than a month, on virtually no new information?

      2) Shareholders elect a Board of Directors to oversee their interests in the company. They ultimately have control. If there is a “majority owner” of a company, i.e. an entity that owns more than 50% of the outstanding shares, that owner will have ultimate control. This is rarely the case with publicly traded companies. Most of the time, there is no majority owner, but there are large shareholders. The large shareholders can wield a good bit of power, especially by banding together with other large shareholders. But ultimately, power comes down to voting rights, which all common shareholders have in proportion to the percentage of outstanding stock that they own. From a practical perspective, it’s worth noting that some companies are more friendly to shareholders than other companies. Personally, I like to see companies that practice what is often called conscious capitalism, meaning that they properly balance the interests of all stakeholders to the business. Stakeholders to the business are primarily: owners, employees, and customers. But, it also includes entities such as the countries, states, cities, and communities in which the business operates, suppliers, other businesses with which it has a relationship, etc. Corporate governance refers to how well a company balances the interests of stakeholders. There is an organization known as Institutional Investor Services (ISS) which rates companies on various corporate governance issues. Their corporate governance QuickScore can be accessed from Yahoo! Finance’s company profile page. Click here and look at the upper right side of the page for an example: http://finance.yahoo.com/q/pr?s=T

      Companies generally use cash profits to do one or more of the following: 1) Invest in new capital projects to earn even more profits in the future 2) Acquire existing companies 3) Buy back their own stock, which reduces the number of shares outstanding, thereby increasing each owner’s share of future profits 4) Pay down outstanding debt 5) Make cash payments to holders of common stock in the form of dividends.

      So, yes, you do get some share of the profits paid directly to you as long as the company is paying out dividends.

      3) The short answer to this question is NO! Absolutely not. First of all, when you sell a stock, it could be for any number of reasons. For example, it could be because you simply need to money. But if you are selling because you believe the stock is overvalued, or that the future does not look very bright for this company, you have to realize that is only your opinion of the stock. Other people have other opinions. But, the market (and regulatory bodies) do realize the moral need for a level playing field for all investors. In other words, we all need to have public access to the same information. That’s why it’s illegal to trade stocks based on “insider knowledge”, i.e. knowledge that has not yet been made available to the public. For example, say that my brother works for a small defense contractor that is about to lose its largest contract from the government, thereby cutting its revenues in half. Say my brother gives me a head’s up on that before the information is made publicly available. Now, if I take that information and sell the stock to someone who doesn’t know what I know, not only is it unethical, it is also illegal. If however, I wait until the information is made public, and then sell, I’m doing nothing wrong. That’s because the market will absorb the information almost immediately. Shares will be trading immediately much lower than they were, and I will have to settle for the lower price. But, as long as the playing field is level, our interpretation of publicly available information may very well be all over the place.

      What you have to realize is that stocks are not a zero sum game. In other words, if I’m winning, it doesn’t necessarily mean someone else is losing. Publicly traded companies are pretty good at growing their profits over time, which allows for most investors to make money by investing in stocks. If I hold AT&T stock for 10 years, and then sell it to you tomorrow for a nice profit, you may hold it for the next 10 years and earn nice profits yourself. There’s a million different reasons why people buy and sell stocks on any given day, and most publicly traded companies have many thousands (some many millions) of shares changing hands each day. It’s a lot of work trying to find good companies whose stocks are trading at reasonable valuations. I have absolutely no moral qualms about doing my research and due diligence and trying my best to make good investments. Neither should you, in my humble opinion.

      I hope this helps. Please feel free to post any follow up questions you may have.

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