How to Develop Your Approach to Stock Market Investing
December 13, 2013
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:
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.
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
* 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.
Please feel free to use the comment boxes below lessons and articles as a means of posting questions or giving feedback. You can login using your Facebook, Twitter, Disqus, or Google account. We want this to be as interactive as possible. There are no "dumb" questions. This is a place to learn!
If you enjoyed this article or found it useful in some way, will you please help us get the word out by sharing this link on social media? You can use the buttons on the left side of the page to do so.
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.