The stock market has proven a great investment over the last century - investing prudently and in a disciplined way in the stock market would have yielded great results in every two-decade-long period in the US. This means that no matter where you start in the last 100 years (even a day before the collapse that started the Great Depression), if you invested wisely (meaning you diversified and dollar cost averaged into the market), you would have been far better off by investing in 20 years than you would have been holding the money in cash instead.
If this is the case, why are so many people so afraid of buying stock? Here are 3 reasons why:
1. You Don't Understand What a Stock Actually Represents
If you're afraid of investing in the stock market, you might simply not understand what a stock actually represents - you literally don't know what it is. Of course, you've heard of stocks and you know they are some sort of financial instrument or products, but if pressed you probably can't give even a basic definition that would clearly define what a stock is.
If you're in this camp of people, it does make a bit of sense that you're hesitant to invest in equities and delve into the stock market. People are often (and often rightly) afraid of what they don't understand - human nature keeps us safe by making us a bit frightened of the unknown. If you don't really know about something, how can you know if it's good or bad? Just as importantly, if you don't know about something, how can you know how to deal with it in productive and effective ways? Maybe it's better to just stay away from those things you don't know?
Staying away might be a good idea for some things in life, but it's a bad idea when it comes to delving into the equities market in your financial life - by not investing in companies around the world through the purchase of shares on the stock market, you are denying your financial self and your portfolio one of the best ways regular individuals can have a piece of the global financial pie and ride the wave of global growth over the long term. Without investing in stocks, you're not going to benefit when global GDP increases - you're going to have to rely either solely on your own labor income or a bit of interest income you'll earn by letting other people use your capital. Buying shares of good firms around the world, however, will allow you to literally have an ownership state in the global economy.
So, if you don't know anything about stocks today, it's time to learn. Fortunately, you're already ahead of many others because you're here reading this on this website - you've already taken a crucial first step. Next, you'll want to pursue around Pennies and Pounds a bit more in a free-form way to just get a feel of the kind of stock-related information that is out there. Once you've got a general conception, a book or two will prove quite useful in helping you delve deeper and learn more about personal finance and the stock market. Never underestimate the importance of learning about personal finance - your financial life is a key part of your overall life and not spending any time in studying up is as foolish as not going to school but expecting to do well in the job market.
2. You've Invested in the Stock Market in the Past, but You've Been Burned and Remain Scarred
Maybe you do know about stocks. Maybe you've even ventured out into the equities market in the past. And maybe you've been burned by it. Maybe you've
If the above happened to you, it's no surprise you're hesitant to go back into the stock market. You probably feel like
Although it's understandable that you feel this way, it's totally wrong - you're wrong if getting burned in the past has fundamentally created a negative outlook of the stock market for you. You got hurt in the past not because there are fundamental flaws in the stock market or that investing in stocks is simply not for you - you got burned because you made incorrect decisions.
Investing in stocks well requires a certain amount of basic knowledge. Things such as
If you got burned in the past in the stock market you probably bought a single stock or just a handful of stocks - this is foolish unless you're a Warren Buffet and for most people proper diversification is key. If you invested in Lehman Brothers or Pets.com or any other hot stock pic, you would have gotten burned - you invested without diversification and you invested in the wrong thing.
If you're going to stock pick, then make sure you pick the right stock. is not possible for most and, therefore, stock picking should be avoided like the plague. Instead, diversification via the use of mutual funds and exchange-traded funds (ETFs) should be utilized with a few stocks here and there if you're willing to take on the risk. Additionally, a robust (but not too robust) cash position (that is separate from your emergency fund) would provide liquidity and help reduce the overall volatility of your portfolio.
You also might have gotten burned because you invested at the wrong time (eg. the Dot Com Bubble or in 2006/7) and then sold at the wrong time instead of waiting for the market to recover. Instead, you should have:
Instead of going in at once, a dollar cost averaging approach where you invest a bit every month or every quarter allows for less risk because instead of investing at a single time, you can take advantage of market drops by having your money purchase more stocks, mutual funds, and ETFs. Additionally, you must be disciplined enough to not sell in a market panic - this is very hard and this is what kills most investors. You need to study the history of the stock market and keep that history in mind in order to temper the craziness that will arise in your mind when you see your portfolio going down. A good investor that is invested in a strong and diversified portfolio will not sell at a panic - this investor will understand how foolish it is to liquidate positions at a market drop and will instead keep disciplined and follow through with his or her investing strategy.
3. You've Heard too Many Stock Market Horror Stories
Maybe your dad or your uncle got burned investing in stocks. Maybe a high school teacher told you about her venture into the stock market and how horribly it turned out. Maybe your grandparents' told you stories of the Great Depression and how they only hold cash and bonds. Maybe you've watched one too many news episodes during the Great Recession. Maybe you grew up in a house where there was a lot of misunderstanding and fear about the stock market.
Whatever or whoever go this fear into your head - it's not rational. Stocks have created tremendous amounts of wealth for both rich people and middle-class people over the last century. The Great Depression, the Great Recession, Black Friday, the Dot Com Bust, and all of the other horrible things that happened in the financial markets would not affect an investor that was properly diversified and dollar cost averaging (instead of going all in at once). It's normal that hearing of other people's failures when investing in stocks would make you cautious, but it doesn't have to be that way - you can easily succeed in the stock market if you take a disciplined and prudent approach. More importantly, if you're going to really build wealth and not simply rely on your own income, the stock market is one of your best bets.
Although a tax return means you've given Uncle Sam an interest-free loan over the course of the year -- something that probably isn't the best thing to do if you're a mature adult who knows how to handle money -- it can be a financial boost for many individuals and family in the early part of the year. In a sense, you've been forced to save over the year (you can think of it as forced savings account) and now you are to decide what to do with that savings.
Don't make the mistake of thinking that your tax refund is some sort of windfall or a gift from the government or some sort of unexpected gift that you didn't earn - your tax refund is literally your own hard-earned money that you've been forced to pay the government over the course of the year. Keeping this in mind, you should treat your tax refund like you should treat all of your money: with care, planning, and prudence. Below are a few key things you can do with your tax refund to improve your financial situation and add a bit of financial peace to your life.
1. Start or Increase Your Emergency Fund
This is Number 1 on our list of things to do with your tax return because for most people a strong emergency fund is the single best first step then can take to securing a better financial life.
Those that have some sort of guaranteed income might not need a rainy day fund as much as everyone else because there is far less volatility in their monthly income - for the rest of the world an emergency fund stands in between you (and your family) and financial disaster, stress, and worry should something unpleasant happen (and in this life, something unpleasant usually does happen every once in a while).
Getting your emergency fund to a solid level (typically 3 to 6 months of living expenses) is usually even more important than paying back even high-interest debt. A person with a large amount of credit card debt and nothing in the bank at all clearly is exposed to a lot of suffering if he/she loses their source of income or if an unexpected event or emergency comes up. Of course paying down the debt is very important, but without an emergency fund, there is too much exposure to even the slightest financial emergency.
Without any money, a job loss, a flat tire, a leaky roof, prolonged sickness or any other of the many things that can go wrong, will lead to a lot of pain in your life. Having even $1000 in the bank will help shield you and having a full 3 to 6 months of living expenses in the bank will give you a very pleasant calm in knowing that you've got enough stashed away to make it through most financial emergencies.
If you don't have an emergency fund, a tax refund can be used to start one at your local bank - better yet putting that money into an online savings account where it's a bit harder to reach might be a better option.
2. Pay Down High-Interest Debt
If you already have a proper emergency fund in place, the next best thing to do with your tax refund is to pay down high-interest debt. Such high-interest debt can be credit cards, personal loans, consumer lines of credit, and car loans, etc. These all qualify as bad debt in most cases - things like student loans, mortgages, and business loans (although clearly undesirable) are better because they generally carry a lower interest rate (because they are backed by either tangible assets or are not-bankruptable) and are generally taken out for thins that increase in value over time. Paying down high-interest debt will save you money on interest, will strengthen your overall financial position, and will bring some peace into your financial life.
There are two options when paying down credit card debt:
Generally, either of the above will work and actually pay down debt aggressively is more important than which of the above methods you choose. However, you can decide how to approach paying down your debts based on your own understanding of your personality - if you're the kind of person that might need a momentum boost by seeing a credit card fully paid off, then maybe focusing on the smallest balance is better for you even though it's not the best approach from a purely mathematical standpoint.
3. Take Advantage of a Bank Bonus Offer
If you've already got your debt situation under control (meaning you don't have credit card debt or other high-interest debt as described above), then you might consider using your tax refund to get even more money via a bank offer where you get a bonus for opening up a savings account.
Online banks such as Capital One 360 and even brick-and-mortar banks such as Chase often offer bonuses for opening up a new savings account. The general gist of it is that if you deposit a certain amount of new money (eg. $10,000), you get a bonus.
One offer online was for a $200 bonus for a $10,000 deposit - this equates to an almost immediate guaranteed return of 2%. To get 2% in the markets you would have to expose your money to a bit of risk. To get 2% in a guaranteed way (like you're getting with this bonus) you would likely have to lock away your money (circa 2017) for a period of at least a couple of years. Clearly, an almost immediate 2% gain is quite lucrative a low-interest rate environment and taking advantage of such an offer could give you extra boos on top of your tax refund.
4. Open an IRA
If you don't have an Investment Retirement Account (IRA) or if you're not currently contributing the maximum amount allowed, opening an IRA could be a useful way to store your tax refund and it can help lower your tax burden next year (as long as your income during the year in which you're putting the money into the IRA at least is as much as your putting in). You might want to speak to your tax professional about the best way to approach it and if this is really a good idea for you, but for most people, an IRA can help lower taxable income and, thereby, lower the overall tax burden for next year.
5. Start a College Fund for Your Children
If your financial house is in good shape, it might be time to start thinking about college for your kids (or their financial future in general). Whether college is a few years away or whether you have a newborn, saving for college is always a prudent idea and it will greatly benefit both you and your children.
A good idea is to save the money in a place where it can be used for non-college expenses. The world is rapidly changing and if your child is very young, it is not easy to predict what the academic or occupational landscape will be like in 15 years - college might be drastically different and so might college expense. Therefore, it is prudent to save in a place where your hands won't be tied in terms of how to use the money and where you won't have severe penalties if you or your child chooses to use the money for non-academic expenses (eg. starting a business, paying for a wedding, buy a house, or whatever other hopefully useful endeavor he or she chooses to embark on).
Bill Miller is another excellent, but not someone as widely known as Benjamin Graham outside of financial circles. Miller spent 35 years at Legg Mason Capital - his last role at the asset management firm was as Chairman and Chief Investment Office (CIO).
During his time there, Miller was able to beat the S&P 500 (in after-fee returns) for 15 consecutive years (from 1991 to 2005). This spectacularly consistent and exceptional performance is considered highly improbable per well-known financially theory that says the market is efficient and that above-market returns will most likely arise to do chance.
If there is a 50-50 chance of beating the market (the S&P 500) on any given year (as the Efficient Market Hypothesis would lead us to believe), the chance of beating the market for 15 consecutive (eg. flipping heads 15 times in a row) is 0.0031%. Miller's approach, therefore, seems to be more than just pure luck and many investors believe that his deep value-oriented approach to picking stocks can consistently produce market-beating returns if applied in a disciplined and knowledgeable way.
Market Cap Less than 3X Free Cash Flow (FCF) for Next 5 Years
The first screen wants us to only allow those firms whose market capitalization is less than three times the total estimated free cash flow (FCF) over the next 5 years. Here we are clearly looking for undervalued firms in terms of earnings, but we're not looking at the typical price to earnings (P/E) ratio that most investors look at - Bill Miller is concerned not with profits but with free cash flow (FCF), an important measure that is much harder to manipulate than is profit by the firm's bookkeeper.
A firm can make a profit but lose cash. A firm can lose money but be raking in cash (this is the case with Amazon). The reason for this has to do with accounting principles and how they have to be applied for publicly-traded firms reporting their quarterly earnings. Without getting into the weeds here, the nature of financial reporting leads to quite unintuitive representations of things - profit on the books might not translate into real cash every quarter and losses might not really be as bad as they might sound if cash if rolling into the firm's bank accounts.
By eschewing profit nad focusing gon cash, Miller moves toward a more realistic and intuitive measure. By looking at those firms that have a market cap less than three times the esteemed free cash flow (FCF) over the next 5 years, we are effectively putting a maximum multiple over free cash flow (FCF) on the firm. This means that we expect the full market cap to be repaid within the next 5 years in free cash (not in profit). This is a powerful criterion that will leave relatively solid value plays in terms of free cash flow (FCF).
Price Earnings to Growth (PEG) Ratio Under 1.5
As with Peter Lynch and Phillip Fisher, Miller also focused on the P/E to Growth (PEG) ratio. However, unlike Lynch whose screen includes a filter to eliminate PEG ratios greater than 1 and Fisher whose screen only seeks to include PEG ratios between 0.1 and 0.5, Miller is more aggressive in terms of accepting a higher PEG ratio of 1.5.
In this screen, although a PEG of 1.5 still is reasonable, the PEG filter can best be understood as eliminating overly expensive items rather than being a hard screen for deep value plays. If that was the case, the PEG ratio would likely be lower - around 1 or less.
Long-Term Debt Ratio Below Industry Average
Finally, if we're looking at value plays in terms of market cap to free cash flow, we want to make sure that the deep value present isn't because the firm is over-levered - we want to make sure the firm isn't burdened by excessive debt as debt can be a killer both to the ability to effectively use the cash the firm generates and because it creates a lot of risks.
By looking at firms with debt ratios below the industry average, we can be sure that we are being conservative in our stock pick. Combined with a reasonable PEG ratio and a low market cap relative to estimate future free cash flow (FCF) over the next 5 years, we can paint a full picture of the firm as a reasonably conservative value play.
Philip Arthur Fisher is going to be on the fringe of investors' knowledge - only those that are truly serious and deep in investing and stock analysis will likely know this man's name in our era. Everyone should know his name, however, as Philip Fisher is one of the greatest investors of all time.
Starting his career after dropping out of Stanford in 1928 to work in a San Francisco bank. Think about how astonishing this is - the likes of Bill Gates, Steve Jobs, and other Silicon Valley wunderkinds would follow suit (likely without even knowing who Fisher was) half a century or more later.
Fisher's seminal work Common Stocks and Uncommon Profits is a foundational piece of investing theory and writing that was published in 1958 but has remained in publication ever since, demonstrating how relevant Fisher still is to this day.
Fisher's investing approach was focused on purchasing growth at incredible discounts. Let's take a look at what to screen for if you want to perform stock screening in a manner aligned with Philip Arthur Fisher's investing principles.
Increase in Year-over-Year (YoY) Sales Over Last 5 Years
Here we can already see that we are not going to be playing games with the typical price to earnings (P/E) ratios and similar metrics most investors focus on too much - Fisher isn't going to play in that field but will instead be looking at metrics that evince a strong and growing business.
Year over year sales growth simply means that the current year's sales are greater than last year's sales - we want to see such growth for the last 5 years. Seeing a dip (or even a plateauing) of sales indicates that the business model is either (1) quite mature, (2) is experiencing cyclical difficulties, or (3) the firm's management isn't doing a good job.
Clearly, 1 and 3 above are not good, but many investors would accept 2 and say that the sales decline is simply due to the business cycle or the general cyclicality that the firm's business is exposed to. By required year-over-year sales growth for 5 years, Fisher implicitly answers the investors by saying that if the business is capable of being affected by this type of cyclicity, it isn't the type of business we want to invest in - we want businesses that thrive in good time and do well in bad times (we want robust businesses that can thrive in almost any economic environment).
Price Earnings to Growth (PEG) Ratio Between 0.1 and 0.5
The P/E to Growth (PEG) ratio is simply the P/E divided by the earnings growth rate - it shows you how much you're paying relative to a firm's earnings growth.
In the piece on The Peter Lynch Stock Screen we looked at a PEG ratio of less than 1 - here we take that even further and require an almost astoundingly low PEG ratio between 0.1 and 0.5. We can see that Fisher's approach is to find not just deeply undervalued companies, but deeply undervalued companies in terms of the growth they are exhibiting. In effect, the key in Fisher's approach is to pay as little as possible for as much steady and reliable growth you can get.
Research and Development (R&D) as a Percent of Sales Greater than Industry
Again we are focusing on things that will demonstrate intense growth or growth potential. Research and development is a good indication of a firm's belief of its ability to innovate - generally speaking, if a firm invests in R&D it believes that the benefits derived from the initial capital outlays (eg. the returns) will be higher than other potential capital uses (eg. the opportunity cost) - if a firm invests in R&D, it generally means that they think they have an ability to innovate.
Additionally, successful R&D generally results in growth. Therefore, a firm that is heavily investing in research and development is more likely to be a firm that is either already growing at a strong pace or will do so down the line. By choosing those firms that have a higher research and development expense compared to sales than others in the industry, you have a greater chance to look at firms that are Horwitz and creating new and innovative products/services.
However, it is important to be aware that only looking at research and development expenses as a percentage of sales is far from sufficient - looking only at R&D can deeply mislead you if that's all you look at. For example, imagine a firm that has sales of $1 and R&D expenses of $10 - this firm would have a tremendous R&D budget compared to sales, but we can clearly see that this firm is doomed because it's sales are too low in absolute terms and its R&D is excessively high in relative terms.
Growth in Sales Greater than Growth in Research and Development (R&D) Expenses
Here we see Fisher again focusing on research and development - this time, however, we're focusing on R&D growth. We want R&D growth to be less than sales growth - this will help prevent the plant scenario ($1 sales vs. $10 R&D) discussed above because a growing R&D budget doesn't by itself mean that much. A growing R&D budget that is accompanied by growing sales, however, does mean a lot - sales growth even greater than R&D growth means even more because it implies that the R&D expenses are producing great returns and that the firm is ultimately becoming more efficient in terms of the percentage of sales required for R&D.
Peter Lynch is one of the greatest investors of all time - any investor (or anyone involved in the financial markets for that matter) likely has heard of Peter Lynch.
Lynch managed the Magellan Fund at Fidelity from 1977 to 1990 during which the funds assets under management grew from about $18 million to about $14 billion dollars - this is an increase of about 777x, meaning that $1000 invested in the Magellan Fund under Lynch's helm in 1977 would yield about $777,000 in 1990 - an absolutely astounding return that skyrocketed Lynch into the top echelon of investors not only in his generation but in the history of investing.
In case the above numbers aren't enough to convince you of Peter Lynch's investing genius, let's compare the Magellan Fund's performance from 1977 to 1990 with the performance of the Dow Jones Industrial Average over the same time period. The Dow Jones Industrial Average managed an increase of about 3x over the same period - $1000 invested in the Dow would yield a comparably paltry $3000 in 1990.
Clearly, any investor should at least be interested in the general methods employed by Peter Lynch. Although Lynch articulates some general principles regarding his investing philosophy in the now classic One Up on Wall Street, we will look at what can be called a Peter Lynch Stock Screen - a stock screen that generally uses his principals to screen the universe of potential stocks for a small number of potentially lucrative stock picks.
Price Earnings (P/E) Ratio Lower than Industry
The common price to earning (P/E) ratio is often used in stock screening and Peter Lynch was no stranger of this classic and often used metric. By screening for firms that have a lower P/E ratio than the industry, an investor can find potentially undervalued equities.
In order to perform this screen, one would first need to accurately identify the industry. It's key that the industry classification is not too broad - this will create a more accurate comparison. For example, a luxury car company such as BMW might be better grouped with other similar luxury firms (eg. Mercedes Benz, VW Group, etc.) instead of as part of the car industry as a whole (eg. Ford, GM, etc.).
Once an industry P/E ratio is identified all stocks that have a P/E ratio at or above it can be screen out. More conservative investors might even choose a slightly lower P/E in order to more aggressively target deep value plays.
Price Earnings to Growth (PEG) Ratio Less than 1
The Price Earnings to Growth (PEG) ratio is an excellent metric and is especially useful for high-growth firms. The ratio compares the P/E ratio to the growth of earnings per share (EPS) - clearly, firms that have earnings per share (EPS) growth might allow for greater accommodation of higher P/E ratios because you are paying for future growth.
A PEG ratio allows investors to take the P/E into full account by also looking at EPS - it's possible that a relatively high P/E will be viewed in a much better light when the PEG ratio is looked at.
A PEG ratio below one is a low PEG ratio - it can be said that "growth is being purchased cheaply" with a low PEG ratio.
Insider Buying to Selling Ratio Greater than 1.5
This is an interesting thing to look at and it gives us a glimpse into Peter Lynch's thinking. Who has more knowledge of the firm, random investors or insiders? Clearly, insider buying implies optimism about the future prospects of the firm - relying on this easy to see metric requires no real analysis or calculation and is simply based on an understanding of the nature of knowledge and human society.
Sequential stock screening involves reducing the universe of stocks to a manageable size. For example, sequential stock screening might involve reducing all US publicly-traded stock to 10 stocks for use in a portfolio by eliminating stocks, one by one, based on filtration criteria (usually with the most important criteria first.
Although there's no absolutely best way to perform sequential stock screening, using criteria articulated by the famous Benjamin Graham is both a good way to approach stock screening and an excellent way to better understand some fundamentals that this man (and his successful investing successors) feel are important.
Benjamin Graham -- Warren Buffet's professor and mentor at Columbia University and author of such foundational books in investing as Security Analysis and The Intelligent Investor -- had a stock-picking approach that fundamentally could be described as looking for deep value. He effectively advocated looking for those stocks that were pretty much sure bets but whose current prices were deeply undervalued. The main components of a Graham-style stock screen would consist of the following criteria when performing a stock screen.
Adequate Size - Avoid Overly Small Firms
Adequate size can mean different things for different investors and there's not a hard and fast rule that Graham articulated that we can apply in today's market, but an investor can do one of two things in order to screen for size:
Sufficiently Strong Financial Conditions
This is another slightly ambiguous criterion and can be interpreted in different ways - it can mean having enough cash or not having too much debt (eg. various leverage-related metrics). Things to look at can be:
Non-stop Dividend Payments for Last 20 Years
This is the heart of Graham-style investing - you're focusing on a company that has done well over a very long period of time in the investing world. This would remove:
No Losses for Last 7 Years
This is similar to the dividend requirement - it shows that the firm has been doing well for a significant period of time. Not having losses for the past 7 years (or however many years you might choose - 5 years, 10 years, etc.) will provide some sort of assurance over the quality, resiliency, and robustness of the businesses the firm is in.
As above, this filter will rule out companies where you can't actually observe profits or losses for the last 7 years or companies that haven't existed for at least 7 years.
Increase in Per-Share Earnings of at Least 33% in Last 10 Years
As with the above, this shows long-term stability of the firm's business model - you want to see that the business is at least keeping up with (or beating) inflation in terms of its profits.
Current Price Less than 1.5x Book Value
This is a deep-value filter - we're looking for first that that are trading at only 1.5x book value. Book value can be thought of as liquidation value - book value is different from the market value in that it literally show the value on the "books" of the firm. This filter tells us that we want to buy firms whose market value is only 1.5x the firm's book value - this usually means the firm is reasonably valued.
To compare the 1.5x market to book value we're looking at here and to better understand it in the context of the overall market, let's look at the market to book value of the S&P 500. As of late 2016, the price to book of the S&P 500 was right around 3x, meaning the overall S&P 500 was trading at a price three times higher than the combined book value of all firms that comprise the S&P 500. Near the Dot Com Bubble the price to book of the S&P was about 5x.
Current Assets Worth at Least 1.5x Current Liabilities
This is a classic leverage filter where you look at whether your current assets are sufficient to provide current liability coverage if necessary. The world "current" in finance (for both assets and liabilities) generally means that one year or less - so current liabilities are liabilities (eg. debts) that can reasonably be expected to need to be repaid within one year.
This filter prevents a very unpleasant situation where an otherwise profitable firm might possibly be forced to liquidate productive assets or be forced into bankruptcy due to an inability to cover short-term debts due to adverse economic conditions or a change in the business cycle.
It's important to note, however, that not all of the above criteria have to be used - Benjamin Graham didn't articulate a particular sequential screening strategy but instead articulated principles that are represented in the above filters.
And now, given the rise of cyrptocurrencies and crypto assets to quasi-mainstream financial assets, we're dedicated to providing quality, relevant, and interesting material on cryptocurrencies and cryptoassets. Articles on Bitcoin, Ethereum, Ripple, Cardano, and many more cryptocurrencies and cryptoassets can be found on Pennies and Pounds - all that in addition to a plethora of information on what cryptoassets are, how the entire crypto industry came to be, blockchain/immutable ledger technology, mining, proof of work, proof of stake, and how to prudently invest in crypto if you are so inclined (based on your risk tolerance and ability to withstand the volatility that will come with a crypto portfolio).