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.
How to pick stocks like Benjamin Graham, the godfather of value investing - a robust and reliable stock screen
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.
Invest in firms of 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:
Invest in firms with 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:
Look for firms with 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:
Invest in firms with 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.
Look for firms that have increased per-share earnings 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 should be 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.
When people think of stock screening, they usually think of sequential stock screening - that is they think of taking the stock universe and narrowing it down by applying filters one after the other until a final list of stocks that each meet the criteria is obtained.
Sequential Stock Screening is Binary
One key point is that sequential stock screening is binary - this means that at each point on the screen, the stocks in the stock universe (or the remaining stock universe) either continue or don't continue. Unlike simultaneous stock screening -- which screens stocks simultaneously based on a z-score -- sequential stock screening either keeps a stock in or tosses is out at each junction.
This binary nature of sequential stock screening is considered a weakness by some because a stock may be disqualified early on that would otherwise prove to be excellent given the overall screen (given the upcoming filters that will occur on the screen).
The Initial Investment Universe is the Starting Point for Sequential Stock Screening
The starting point of a stock screen is the initial investment universe - this is simply the totality of stocks that will enter the filtering system. Usually, an investment universe is comprised of publicly traded equities on the NYSE and the NASDAQ.
It is possible to include stocks that aren't traded on exchanges, but this isn't recommended for new investors or those new to stock screening as this can add complexity and can hinder liquidity.
Screen Criteria - What to Look at in Sequential Stock Screening
You can literally look at almost anything in a stock screen - there really is not set requirement. Things such as
can all be looked at in stock screens. There are many sequential stock screening strategies out there but they are beyond the scope of the current discussion.
Many Free Sequential Stock Screening Resources Exist Online - Here are 3 solid stock screeners to try online
Here are a few popular free online stock screeners (that don't require a brokerage account to use):
Other sequential stock screeners exist -- some of which are more powerful than the ones above -- but they are tied to specific brokerage and require you to have an account with them.
Check out the video below for a basic example of how to use a stock screener
This is one of the better YouTube videos available on how to use a basic stock screener. The creator is a reputable individual in the investing community and is known to produce high-quality material.
If you're even a bit serious about analyzing a stock -- whether you're going to use the Capital Asset Pricing Model (CAPM) or whether you're just trying to know the stock's beta to build up some intuition -- you should calculate the beta yourself. Calculating the beta yourself is easy to do and if you either aren't able to do it or are unwilling to do it, you should probably not even be thinking about analyzing stocks at all (instead, you should stick with a far more passive strategy that involves mutual funds and ETFs).
Any serious investor and financial market participants will always calculate the beta on his or her own even if just to do a double-check against a number provided from a third-party source. However, in case you need some reasons to calculate a stock's beta on your own, here are 4 good ones:
1. Calculating a stock's beta yourself will allow all relevant information (until the day of your beta calculation) to be factored in
By calculating the beta yourself, you can literally use all the relevant data available to you through today. A third-party provider will most likely have a time lag. This time lag can be a day our two at best, but it could be almost a quarter at worst. Do you really want to have a beta that is almost 3 months stale? That is a ridiculous proposition when you can easily calculate a beta that will capture every available data point - you can calculate a beta in the evening and capture that afternoon's market volatility in your calculation.
2. You'll get to choose your own time horizon for the beta calculation
The beta you want might vary depending on your investment time horizon. For long term investors who have higher risk tolerances, daily price movements might be irrelevant. For traders or more risk-averse investors, daily price changes might be very important. When you calculate your own beta, you can choose how far back you want to go in terms of obtaining your data (eg. your market and stock prices).
Deciding how far back to go is useful, but clearly more current data is more useful than old data - there's going to be a limit to how far back you'll ant to go. Regardless, choosing how far back you want to go gives you the ability to capture data points in idiosyncratic times that you might care about (eg. an earthquake, a recession, geopolitical conflict, an election, etc.)
3. Calculating a stock's beta yourself will allow you to decide on your own interval
The more important and interesting part of calculating your own beta is the ability to choose the tie interval between data points - you can use daily market and stock prices or you can go longer and choose weekly or even monthly prices. Going longer would likely require a longer time horizon so that enough data points exist to perform solid statistical analysis, but you're really in control when you calculate your own beta and you can decide what you care about. If you think weekly price changes are more relevant to you than daily gyrations, you can easily use that when calculating your own beta instead of having to rely on the assumptions and desires of a third-party.
4. Calculating a stock's beta will build your intuition regarding stocks, return time series, risk, and finance in general
Finally, you should calculate your own beta because it's easy to do and it will build your intuition of what beta is and what it represents. The more intuition you have, the less likely you are to make foolish investing mistakes - the more intuition you have the less likely you are to be led astray.
Once you understand the what the beta of a stock is and what it represents from a finance and a risk perspective, the next step is calculating it. Reading the theory behind the beta is important, but at some point actually calculating a stock's beta for yourself will prove more useful than reading another paragraph of finance theory. Here, we'll walk through a basic example of how to calculate the beta using MS Excel. We'll use the S&P 500 as a proxy for the market and we'll calculate the beta of Facebook (FB) stock.
Step 1: Obtain Daily Stock and S&P 500 Prices for 1 Year
The first step is to obtain daily prices of both the S&P 500 and the stock we're looking at (Facebook in this case) for a period of 1 year. We'll want at least one year's worth of prices in order to capture a full year's economic cycle, include all of the seasons, holidays, and any unique things that might influence the market over the course of a year in our data set.
We'll want to make sure that the dates align - we want to make sure that for every day we have both an S&P 500 piece and an FB price. Basically, what you want to avoid is a situation where you have the S&P 500 price for a day but don't have the FB price for that same day (or vice versa). This should be easy if you're using stocks from the US as bank holidays will generally coincide.
A final point to note is that you'll want the adjusted closing price for each day (as opposed to the general closing price). The adjusted closing price takes things like stock splits into account. Imagine a stock split occurred for the stock you're analyzing halfway through your yearly timeframe - this would make it seem like there was a huge price drop. To avoid this, adjusted closing prices (which are readily available online alongside normal historical closing prices) take this into account and provide (usually) a post-split price for the entire timeframe.
As to where to obtain the data, that should be easy in today's world - you can go to any of the major finance websites to download historical data or you might use your own brokerage account's platform. You can also use a paid data provider, but that's not a necessary expense for most people.
Step 2: Get the Stock and S&P 500 Price Data Neatly into One Excel File
Next, you'll want to copy the data into the same Excel file so you can work with it. This should be easy. Take care to leave a few columns between the data so that you can do the next calculations we'll go over below.
Step 3: Calculate the Daily Returns for the Stock and the S&P 500
Next, you'll want to calculate daily returns (eg. daily price changes) for the S&P 500 and FB. This can be done in two ways:
simple return: (today - yesterday)/yesterday
log return: ln(today/yesterday)
For the most part, simple returns will suffice. Sometimes log returns are useful because they inherently assist with normalizing the data, but that's both beyond the scope of this discussion and unnecessary for us here.
It's easy to calculate simple daily returns in Excel (see the formula in the image below). Once you have a single cell filled out, you can drag the cell all the way to the bottom to create a time series of daily returns for both the S&P 500 and FB.
Note that for the very final day (here it will be the first day in our time series), you won't be able to calculate a return - you'll get an error message in Excel. This is because you won't have a price for the previous day and you'll effectively be dividing by zero. This is not relevant for our purposes and this can safely be ignored.
Recall that the beta can be calculated by using the following formula:
beta = cov(x,y)/var(x)
where x is the stock and y is the S&P 500 and where var(x) does not equal 0.
So, we must calculate two things:
You can see this in the below images - notice the highlighted formulas and the sections of the Excel sheet they reference.
Finally, you simply divide the two obtained numbers per the above formula - notice this in the image below where we divide the obtained covariance by the obtained variance.
We now have our beta for FB - it's 0.861 as of the end of February 2017 - remember that this can change as the market changes and as Facebook changes. We'll notice that the beta is less than 1 - this means that Facebook stock is less volatile than the market (as represented by the S&P 500).
Step 4: Calculate the Two Subcomponents of the Beta Formula
A Bit of Intuition Building - Let's Graph the Stock Movements
We now have our beta, but let's go even deeper to build some intuition around the number. Below, we have created two portoflios, each consisting of $10,000 - at the outset, we invest the full $10,000 in either the S&P 500 or Facebook. So, at the beginning of our time series (February 26, 2016), we have the following:
We're doing this because we need to somehow compare the prices - if we only look at the movement of one share of the S&P 500 vs one share of FB, we won't get a clear picture because the starting numbers are different. What we care about is not the absolute amounts, but the relative movements of both.
Below you'll see a graph of how the portfolio would have moved throughout the year - this is literally what would have happened had $10,000 been invested as we described above. Here we see some interesting things:
An introduction to Beta, a foundational concept in finance that measures exposure to general market risk (systematic risk)
A precursor to truly understanding the concept of Beta is an understanding of the difference between systematic (unverifiable) and unsystematic (diversifiable) risk. These terms sound complicated, but they really aren't.
Here's a very brief review of the difference between these two types of risk:
Keeping in mind the above definitions, it would be useful to know how much systematic risk you are being exposed to with a given security (eg. a stock) relative to the market as a whole. Stated another way (and hopefully more simply), if you're going to hold a stock, it's useful to know how risky that stock is relative to the market - this knowledge will allow you to understand how the stock will fit into an already diversified portfolio and it will also allow you to use the important Capital Asset Pricing Model (CAPM) down the line. Stated yet another way for the purposes of clarifying a possibly confusing topic, the beta of a stock will allow you to know the market risk of the stock (the risk arising from general market factors) - it is not, however, a measure of the idiosyncratic risk fo the stock.
Boats, Water, and Rain: An Example to Help Clarify the Meaning of Stock's Beta and Why We Care About It
A question that arose for me in studying finance was in this effect:
If we are only looking at systematic (eg. market risk), why would any stock have a different exposure to market risk? If finance theory says that there is a certain risk called diversifiable market risk that you're still exposed to even if you have a diversified portfolio, why would betas be different? Shouldn't all betas be the same?
Stated another way, this question might sound like:
Why does beta tell you about systematic (market) risk and not unsystematic (idiosyncratic) risk - and why does that even really matter?
This question evinced a deep lack of understanding of finance and further study clarified things for me enough so that the question itself seemed foolish. I will attempt to provide context here so that such foolish questions don't arise.
Let's leave finance altogether and travel to a port. In that port, there are wooden boats of all shapes, sizes, and designs on the shore. The port is open and you can take any one of them and go out into the water. The port has constant clouds overhead and there is constant rain. This is a unique port b/c the rain is different in different places - if you're standing on the beach and you walk just 10 feet to another direction, the amount and strength of the rain will change.
Now, imagine you take a boat out into the water. You'll feel the rocking and the swaying of the water. No matter where you are in the port area, you're going to feel the water. If a heavy wind storm comes in, all boats will be affected. If it's calm today, all boats will be calm. The way your boat feels, however, is going to be based on the design of your boat - a large heavy boat will sway less than a small boat and a swiftly designed boat that can cut through the water will react differently than a rugged boat. Before you go onto the water, in anticipation of the chaotic rain in this unusual port, you can easily construct a quasi-roof over your boat to totally protect you from the rain. You can choose to go out with no roof at all and be totally exposed to the rain. You can choose to go out with a poorly made roof and just have limited protection against the rain. You can also choose to go out with a fully-built roof and be totally protected from the rain.
You go out into the water now and some wind comes in. No matter what you do, your boat will be affected by the water moving. This is like systematic risk - all boats are affected by it. This risk is not diversifiable - no matter what you do, if you're in the water (eg. if you're in the market), you are exposed to this general risk of moving waters (eg. general market risk). So, if a systematic risk is moving water, a unysystematic risk is the rain - you can choose to diversify that risk away by simply putting up the roof we discussed earlier. You don't have to be exposed to it and many people on the water probably aren't because they've put up roofs - this risk is idiosyncratic to each boat and is diversifiable.
In choosing a boat, therefore, you might want to think about a few things. For one, you might want to decide if you want a roof up. Another important thing to think about is the shape of the boat. Since you know the water will move and you will always be exposed to that movement, you'll want to know how your boat will move relative tot he movement of the overall water. You'll want to look at each boat and think about whether or not it will move calmly or forcefully whenever the water moves. Forceful movement isn't necessarily bad, but you'll still want to know what kind of a journey you're about to have.
This looking at the boat and seeing how it will react to movements of the water is exactly what the beta is about - knowing a stock's beta will allow you to know how the price of that stock will move relative to moves in the market overall. Clearly, the beta then will not tell you about idiosyncratic risks (just like the shape of the boat will not tell you whether or not you'll be exposed to the rain - that's something for you to decide based on your diversification). It's not up to you to control as stock's beta just like it's not up to you to control how the boat will move - the boats are there laid out for you and built already, you can simply choose a pre-built one.
Going further, we now can see that just because the water moves a certain way (eg. just because the market goes a certain way), it does not at all imply that each stock will move the same way. It is obvious when we think of our port - no one would ever question that boats designed differently would move differently in the water. By the same token, it should be easy to see that firms (which are comprised of different people, processes, assets, liabilities, products, knowledge, etc.) will move differently when the overall market shifts and changes.
Why do firms move differently with the market?
Going a bit further, we can ask what the underlying causes are for different betas (for different movements relative to market risk). We know why the boats move different (because they are designed differently), but understanding why firms move differently is a far more complicated matter.
Firms are different in many ways. Some of these ways include:
These things, and much more, clearly influenced the way a firm's cash flows and stock price (which is dependent on both cash flows and overall market sentiment int the short run) will change based on changes in the market. A firm located in a single US state in Middle America that sells basic goods to people of that state exclusively is clearly exposed to less market risk (eg. less geopolitical risk, less market risk, exchange rate risk, economic downturns, etc) than a multinational firm that produces services that businesses generally purchase in prosperous times but can do without in difficult times. Clearly, one firm's beta would be less than the other if the beta is a measure of a firm's relative exposure to market risk.
Quick Note on the Beta of the Market
The beta of the market (eg. the beta of the S&P 500) is said to be 1. This will make sense further down the line because we will see that the beta is calculated by seeing how a stock's prices more relative to the S&P 500. A beta greater than 1 indicates a stock more volatile than the S&P 500 and vice versa - clearly, then the S&P 500 will have a beta of 1 because it moves with perfect correlation to itself.
Another Quick Note on What Diversification Means
Now that we've gone through the basics, we must define diversification. True diversification when discussing beta and when saying that an investment is diversified involves holding the entire market - meaning all stocks, all bonds, all real estate, etc. (or a portion of a basket of them). Holding just a diverse portfolio of stocks still exposes the holder to idiosyncratic risk - they are exposed to shocks that only or primarily affect the stock market.
Now, it is difficult and cumbersome to use as total market basket - one doesn't really exist because it's hard to value things that don't have regular market prices like stocks. Therefore, most finance texts use a proxy for the market - that proxy is the S&P 500 most of the time. We'll note that this is a weak proxy because it only focuses on 500 major US stocks - ignoring all of the other stocks and asset classes that one could invest in. Keeping that in mind, we can proceed with using the S&P 500 due to the fact that it is commonly used and that it will still produce reliable results and metrics for our use and understanding.
And Finally...How to Actually Calculate the Beta
We've spent a lot of words and sentences discussing what the beta is, but without an actual walkthrough of the calculation, the entire concept is likely to still be obscure to those who have not studied finance before. Let's dive right into the calculation.
Another way to take the beta is the correlation of price movements of a stock to price movements of the S&P 500 (eg. the market). We talked about risk before this, but in order to actually quantify these concepts, we must move from a world of words to a world of numbers. We can do that by talking about prices - risk can be represented by volatility (by price movements). We can look at the price movements of a stock and the price movements of the S&P 500 side by side and see how the move - they might move in tandem, the stock might move more aggressively than the S&P 500 (more volatile - higher beta), or it might move more calmly than the S&P 500 (lower volatility - lower beta).
In order to get the numbers (both the stock you're looking at and the S&P 500), you can simply use the internet to obtain historical prices - it's a relatively simple exercise. You'll want daily prices and you'll want to make sure that the data lines up in terms of day and the exclusion of weekends - you'll want a day-to-day match up. Additionally, if any stock splits occurred over the period you're looking at, you'll want to take the post-split stock price for the entire time period - this will avoid adding a lot of error because if you don't adjust the price it will seem like the price dropped significantly on the day of the split. It's pretty easy to use a post-split number for the entire period (post and pre-split) because most online repositories of historical stock data will do this for you automatically.
Next, you'll have to calculate daily returns - this is simply done with the follwoing formula and should intuitively makes sense:
return = (today's price - yesterday's price)/(yesterday's price)
This is a simple percentage change over a single day and this should be done for both your stock and for the S&P 500. You'll now have a list of daily price changes for both the stock and the S&P 500. The reason we look at price changes is because we want to see how the movements of the stock related to movements of the s&P 500 - in effect, we don't really care about the absolute prices of either the stock or the S&P 500 but are only concerned with their movements over time.
One important thing to note is that you'll want to capture enough time within your analysis - you'll likely want a full year's worth of data.
Finally, you'll compare the price movements of the stock to the S&P 500 using the most commonly used formula for calculating the beta of a stock:
beta = cov(x,y)/var(x)
where x is the stock and y is the S&P 500 and where var(x) does not equal 0.
This formula might seem complicated, but it really isn't - it can be easily explained and easily performed din a program such as MS Excel using the functions COVAR() and VAR() over a list of price changes.
Covariance (which is represented by cov in the above formual) is simply a measure of the joint variability of two random variables - it's a measure of the degree two random variables (here the random variables are the price changes) move in tandem with each other. Variance (which is represented by var in the above formula) is simply a measure of how much a random variable (here the random variable in question is S&P 500 price changes) moves about its mean.
Once you have the covariance of the stock and the S&P 500 and the variance of the S&P 500, you simply divide the two numbers per the above formula to obtain the stock's beta - you now have a very powerful piece of information telling you how a stock moves relative to the S&P 500 (which is a proxy for the market). You now know how risk the stock is relative to the market and how much risk the stock would add to a diversified portfolio - you now know the systematic (undiversifiable) risk of the stock.
The 5 types of beta
We touched on this above, but let's formally review the possible betas:
There are No "Bad" Betas
Remember, in no place did we say that any beta measures are bad. A beta of less than 1 is not bad. A beta of greater than 1 is not bad. Beta simply tells you how much the price of a stock varies relative to the market, it does not imply anything beyond that. A beta of less than one might be desirable for a conservative investor while a high beta might be desirable for a more aggressive investor who is looking for more return. A stock's beta tells us a bit about the expected turn of the stock with higher betas indicating higher expected returns - this makes sense because more risk should entail more reward. However, this discussion about translating beta measures into an understanding of a stock's expected return is beyond of the scope of this present discussion.
1. You're too little risk in your portfolio, so you're going to have a very hard time beating the market
Proper finance goes far beyond the cliche risk vs. reward thinking, but there is some truth in that oversimplistic expression of financial theory - you must expose yourself to at least some risk in order to obtain returns. A portfolio that is without any risk will only earn the risk-free rate. Portfolios that aren't exposed to less risk than other, all else equal, will generally earn less than more risky portfolio.
Obviously, prudence would dictate that the proper amount of risk be taken, proper risk mitigation tactics should be used, and preferably deep value investments will be made in order to create extremely low-risk higher return investments. However, shying away from any risk or taking too little risk will usually lead to subpar returns.
Investors should examine things such as the following in order to better understand their risk tolerance:
This means that a single 30 years old earning $100,000 a year with a healthy emergency fund is likely not exposing himself or herself to enough risk if they have the vast majority of their money in CDs. They would do themselves a big service by prudently moving some money into the stock market so that far higher returns over the long run can be gained. Such a move could move the return of the portfolio from 2% to 8% - a difference that will likely mean millions of extra dollars over the course of a full investing life.
2. You are churning your portfolio too much - excessive trades lead to poor investing outcomes
Too many investors buy and sell and buy and sell and buy and sell. They spend ridiculous amounts of mental energy, precious time, and precious money on trading fees attempting to:
Churning your portfolio will cause damage for the following reasons:
You're not a hedge fund or a trader. You don't have a supercomputer sitting near Wall St. You don't have PhDs working for you. Play the game where you have an advantage, not the game where you are deeply handicapped. Buying calmly and sitting is usually better than heavy coughing for most investors.
3. You're trying to pick stocks, BUT you're a terrible stock picker
Top investors such as Warren Buffet and Monish Pabrai can pick stocks - they have a true talent for it and they spend their lives doing it. What makes you think you can compete with them? Would you enter an Olympic swimming competition just because you enjoy taking laps at the local YMCA? No - that would be ridiculous. So, why do you think that you are capable of picking stocks when the cards are deeply stacked against you?
Of course, some small time investors are great at picking stocks. They are talented and lucky. If this is you, you don't really need this advice. But if you keep putting in time and energy tiring to pick the next five bagger or ten bagger only to see your portfolio trail indexes such as the Dow Jones or the S&P 500, you must ask yourself why you are wasting so much time. Why not just sit back, buy the index, and relax?
Take a hard look at your portfolio if you're in this camp and be honest with yourself. You can leave a bit of play money to mess around with, but the majority of your money might be better off in excellent mutual funds and ETFs that track both US and global indexes. These mutual funds and ETFs can be matched to your risk tolerance and time horizon and they offer market returns at almost no effort to the investor.
The Complete History of the Dow: The changing companies that made up the Dow Jones Industrial Average since the prominent stock index's inception
The Dow Jones Industrial Average is one of the longest-running stock market indexes in the world. Its components have changed since inception - they've changed 51 times since the inception of the index by Charles Dow.
Looking at the Dow Jones Industrial Average's (or simply the Dow's) components over time allows us to see how American business (and the world in general) has changed over the last century and a half.
We won't go into all 51 component changes here -- you can find them elsewhere if you'd like -- but we will focus on the most interest and relevant ones and discuss them in a bit more depth than you can find elsewhere on the internet. Instead of giving a cursory overview, we'll dig a bit deeper to see what underlying changes were the root causes of the changes and in the process, we'll gain the following benefits:
The Dow on July 3, 1884 (precursor)
The initial Dow (which wasn't properly the Dow Jones Industrial Average but was instead a creation of Dow called the Dow Transportation Average) consisted of the following:
As the original "Transportation Average" name should indicate, the original Dow components were heavily focused on transportation. We can clearly see that there are a lot of railroad companies represented in the initial Dow mix. In the 1880s, railroads had been around for a few decades, but they still represented the new and happening industry - similar to how technology is today fast growing and focused on thing in business even though computers have been around for a few decades already. Railroads represented Manifest Destiny and a new industrial era where lots of money was being made in the business of moving things from one place to another.
We see that 9 out of the initial 11 firms represented in the 1884 Dow were railroad companies - that's a very large representation and should clearly indicate the importance of transportation generally (and railroads specifically) in the pre-20th Century US economy. As the country moved westward and as more and more goods were in need of rapid transportation in the post-Industrial Revolution era, railroads were able to extract very healthy nominal and real profits.
Basically, a discussion of the early years of the Dow inherently is a discussion of railroads. The first public railways opened up in the US in 1830 using steam engine - by the 1880s, technology had improved as did ridership and a need for transporting goods in a new type of economy where self-reliance was beginning to give way to mass consumption and production.
The equivalent today in terms of industry would be seeing all tech firms dominating the Dow Jones Industrial Average - imagine seeing the Dow today composed of the likes of Google, Facebook, Microsoft, Oracle, Salesforce, Twitter, Apple, HP, Dell, Cisco, etc. An observer would think that the US economy was heavily dominated by tech. Luckily for us, today's economy is far more diverse than the industrial and transportation economy of the late 19th century - we have large industrial firms, firms involved in chemicals, firms involved in telecommunications, firms producing basic products, firms that primarily provide services (eg. consulting firms), etc. Today's economy is as diverse as any has been in human history.
May 26, 1896 (the first proper Dow Jones Industrial Average)
The first proper (non-transportation only) Dow Jones Industrial included the following firms:
This was the first real Dow Jones Industrial Average. Here we see many of the railroad companies replaced - only two of the firms (the Northern American Company and the Tennessee Coal, Iron and Railroad Company) are firms heavily involved in transportation.
We can see that the list has now moved away from transportation and is focused important necessities for late 19th Century America. Things like cotton, oil, tobacco, cattle feed, coal, iron, leather and rubber are all represented - these basic necessities were key to a life that was moving away from self-reliance on farms and into a mass-produce economy that required energy (in the form of gas, oil, and coal), straps, linens and other fabrics, heavy metal, electricity, etc.
If the Dow had existed 500 years prior in the Middle Ages, things like electricity, leather, cotton, coal, and rubber would not be there - most of life would consist of cattle feed and other types of feed.
Another interesting thing to note is that the names of these firms are quite basic - they are literally are names of what the company produces. Can there be any doubt that the Tennessee Coal, Iron, and Railroad Company is involved in the production of coal, iron, and railroads? Would you be surprised to find out that the United States Rubber Company produces rubber? These firms were the first of their kind - they are representations of commerce and big business in an era that had only recently exited the darkness of the Middle Ages via the Renaissance. The unique names we see that not only don't represent the firm's products or services but sometimes are not even traditional words that humans have used are only possible in a world that understands what firms are - world filled with people used to branding, buying things from companies instead of from friends or family, and have a lot of trust in business and capitalism in general. The ability of firms to market and brand themselves in order to educate the public about their products and services allows firms today to eschew the basic naming conventions of the past and to use innovative and obscure names such as Twitter or Exxon. A Twitter or an Exxon would be strange in the early years of the Dow - no one would have any idea what these firms produced. Without the ability to create an image of the firm through the use of advertising (which requires a lot - print ads, TV, radio, the internet, etc.), firms would who used strange names would find themselves at a deep disadvantage in the past. It was a far smarter idea to make sure people knew what your business did just by reading the name.
October 1, 1928 (Dow expanded to 30 firms)
As the index expanded to contain 30 firms (the size it's been ever since), the Dow was comprised of the following firms:
Here, the index was expanded to the 30 firms we have today. This was an interesting time in the history of the United States and especially its economic history. The Roaring Twenties were coming to a close and little did anyone knows that the Great Depression was right around the corner.
Here we can see the that we have a few automotive firms represented - we've got General Motors, American Car, Mack Trucks, and Nash Motors. Car companies have come on the market and are now some of the largest firms in the country. A car firm at this time would be similar to seeing the edition of technology and internet firms in the 2010s and 2020s - the firms came up over a few decades and finally took their place among the largest in the US by playing in a new and important industry.
We see that the names here are still those basic names that hearken back to an era before sophisticated marketing and advertising and before readily available means of communicated such as radio, TV, and mass color print.
July 3, 1956
This is the first Dow changes after the US entered WWII - the previous Dow adjustment occurred on March 4, 1939. Since we last saw the Dow above (1928), the US had plunged into a decade-long economic downturn called the Great Depression, entered WWII (which helped it recover), and saw droves of new babies being born in post-war America (the Baby Boom). Let's see how the Dow has been affected:
Here in 1956, we can say that we are in a totally different America. The last time we checked in was in 1928 - almost 30 years later the Depression-era youths fought a war abroad and came back home to have a ton of babies. Although key staples remain in the Dow, we can see the addition of many new firms.
We can see a big variety of firms represented here - car companies, companies producing basic materials, food-related companies, retailers, energy firms, and even a photography company in the form of Kodak. In 1950s America, technology has advanced far enough to make consumer products (photography, cars, retailing, toiletries, etc.) major parts of the economy. A Procter & Gamble wouldn't exist just 50 years prior - people didn't have the disposable incomes to shower often and use toiletries nor did they have a desire to in their mostly self-reliant forms of living. In 1950s America, a firm producing household necessities would make a lot of sense. In the same light, in 1950s America, big retailers, big tobacco, and big car companies all make sense - our conception of that era is of one that has now moved way past the agrarian roots of the United States and now is in the realm of post-WWII technology and sophistication. If you had told the people living through the Great Depression that a photography firm (Kodak) would be one of the biggest in the country, they would have scoffed and not understood why - photography was a luxury and the technology was not all there yet. The same can be said about many things represented above.
August 9, 1976
Jumping forward another twenty years, let's see where this journey has brought us:
In these 20 years, surprisingly little has changed. Only a 5 firms were replaced since the last time we checked in in 1956. By comparison, there over 30 changes from 1928 to 1956 (some back and forth). What you have in this period is a stable period of growth, some merging of firms, and a movement away from those classic self-descriptive names to the more unusual firm names we know of today.
Look above to see the firms that remained in the Dow but changed their names - International Nickel became Inco, Texas Incorporated became Texaco, Swift became Esemar, and Standard Oil of NJ became Exxon. These movements are away from names that clearly state what the firm produces to more esoteric and strange names that don't provide any indication whatsoever about the firm - clearly a reliance on marketing, adverting, and branding is required in order to educate the public and create a mental picture of the firm when such strange names are used. This is possible because we are no in a world of color television, radio, print magazines, and other forms of advertising.
This trend has continued today where almost all new and interesting firms have absolutely strange names that give zero indication of what the firm actually does - names such as Twitter, Facebook, Yelp, Apple, etc. If you took a person from 1850 and asked him to whet he or she tough a firm named Standard Oil or a firm named American Can do, he or she would very likely guess correctly. If you asked the same person to describe what he or she thought a firm like Exxon does (bear in mind this is Standard Oil with a name change), they would have no clue and rightly so because Exxon is a totally made up term. As stated above, such strange names can only work in a modern world filled with modern telecommunication systems and a general populace that is receptive to advertising and marketing.
March 17, 1997
About two more decades after our last stop, a lot has happened - the Cold War is over and we're at the apex of the 1990s economic boom. Here are the Dow components now:
Here we can see more name changes (eg. Chevron and AT&T), continuing the overall movement away from the simple names to the more strange and esoteric ones that require branding.
We can also see that some of the old components (eg. AT&T, Chevron, Exxon, Union Carbide, General Electric, General Motors, Minnesota Mining, Sears, and Union Carbide) still here - times have changed but these good firms have endured for a variety of reasons. Some endured because of good management (eg. General Electric), some because of early entry and the existence of various barriers to entry (eg. General Motors), and many because of luck.
It's interesting that even though we're in the heart of the proliferation of personal computing and the internet, there are few technology firms. This makes quite a bit of sense - it takes time for these new firms to grow to a size large enough that would put them in the Dow (the top 30 firms in the US). Firms like Apple, Cisco, Microsoft, and others might have been making big moves during this era, but they were still growing. IBM and HP are present because they were around longer - IBM was around for almost a century at this time.
November 1, 1999
About two more decades after our last stop, a lot has happened - the Cold War is over and we're at the apex of the 1990s economic boom. Here are the Dow components now:
With the addition of Intel, Microsoft, and SBC, we can see that in just about 2 years, the Dow has taken on some of the tech firms. These firms have grown in market cap by now (due in part to what would later be called the Tech Bubble) and had market caps large enough to allow placement within the Dow. The Dow here contains many old stalwarts but is filled with new firms that were either started within the last few decades or came to major prominence recently.
March 19, 2015
The last Dow Jones Industrial Average change happened in early 2015 - here is the current makeup of the Dow:
In today's Dow, we see the familiar firms that make up the market share and the mind share of the US economy today. We see an almost complete transition away from the simple self-descriptive business names to esoteric and strange names that require branding - compare this final list with the first list. Firms like National Lead, Tennessee Coal, United States Leather, and others are so clear in their descriptions while firms like Visa, Pfizer, Nike, and Apple would be totally obscure if not for branding and advertising.
Another interesting thing is the rise of big pharmaceutical and healthcare firms - firms such as Merck, Pfizer, and UnitedHealth have come to major prominence due to various large-scale factors. These factors include an aging population (Baby Boomers), a more wealthy economy that can spend more on healthcare, and the success of pharmaceutical research in producing new, innovative, and expensive drugs.
We also see the tech firms playing a bigger role - Cisco, Apple, Microsoft, and Verizon are all part of the overall technology economy, helping to provide hardware, software, and telecommunication services.
Rates of return play a tremendous role in investing performance - without adequate returns, it's difficult to build real wealth
A fundamental principle of investing is that rates of return are key - but most people don't really understand their profound importance. Of course, most savers and investors know that the rate of interest they get on their savings or the rate of return they get on their investments matters a lot, but they are too easily willing to give up valuable return to things such as the below.
The common thieves of investing returns
The common thieves of peoples' investing returns have proven to typically be the following:
It's important to note that not all of the above fees are bad - you're paying these for a reason. For example, you want the mutual fund to hire a good money manager - this person will need to be compensated well. You clearly understand that administrative fees are going to exist for mutual funds and ETFs. Trading fees obviously are required so that the brokerage is paid for the service they provide you - this is a small price to pay for being able to enter and exit positions with ease.
However, you still don't want to overpay. You will not want your mutual fund or ETF to spend excessively on hiring poor-performing managers, spring money on lots of useless advertising, or running thing so inefficiently that the administrative fees are too high relative to similar funds. You'll obviously want to shop around to find a reputable and high-quality broker, but not one that charges excessive fees relative to what's available on the market. You'll also want to be disciplined and not constantly enter or exit positions so you don't accumulate excessive trading fees that will eat away at your capital. Common sense will dictate that even if the fees are reasonable in principle, they could be unreasonable in practice (meaning in amount).
To illustrate this point well, let's use an example. Examples are often an excellent way to illustrate importance finance principles in ways that are easy to understand - a theory is good but seeing numbers and graphs often allows people to really visualize the concepts being presented and gives the motivation to use the new knowledge they gained.
Investing $10k at different rates of a return - a simple example
Let's start with $10,000 in our example and let's invest that money at different rates of return - the return rates will be from 0% to 8% in intervals of 2%. First, we'll break down the possible rates and understand where you might obtain them:
Now, let's see how $10,000 will grow at each of the above rates of return by taking a look at the graph below. From looking at the graph we can see that the 0% return stays constant throughout with all of the non-zero returns separating from it more and more over time. We can also see that each 2% increase does not bring a proportional increase in the final amount - the increase itself increases over time.
The 8% portfolio brings the initial $10,000 to almost $500,000 but the 6% doesn't even reach $200,000. We can say how important even a small increase in return can make over the long term. That 2% difference is sadly something too many investors ignore. It makes sense given the human mind's propensities that a person wouldn't be able to totally and intuitively grasp the importance of even a 0.25% difference in return, but through education, we can see that the small differences end up with very big differences in results.
How can a 2% difference result in a greater than 50% difference in the final portfolio value? This doesn't seem to make too much sense at first glances - the 2% difference is only 1/4 of 8%, so shouldn't it result in a 25% difference? The maths of finance don't work this way - this is an incorrect way of thinking through it. The way it works is that the 2% you forgot on the first year doesn't stop there - that 2% you would have gained is no longer able to be around in the second year to earn additional return. For example, by forgoing 2% on the $10,000 investment, you forgo $200 in your first year, BUT it doesn't end there - in the second year that $200 would have been working for you t earn a return. The same is true in the third year, the fourth year, and so on. In effect, the person who invests at 8% is able to not only bring along that extra amount every year but to also keep that amount invested and earning. In effect, changes in investment returns compound over time. This is the underlying principal as to why small differences in return can have tremendous impacts in final portfolio value.
We aren't going deep into the maths here, but you can reference a 2013 article titled "The Arithmetic of Investment Expenses" by William F. Sharpe. The article is accessible to most readers and the title should give you a hint at the complexity of the maths - it's not very complex to calculate nad understand the impact of fees on final returns.
Next, we'll present another graph - this time with the same $10,000 initial investment but now we'll look at a broader spectrum of return rates (0% to 18%).
As we did above, let's take a look at how each of the additional returns can be achieved:
As you can see from the graph, the initial investment returns we plotted on the first graph are made to look minuscule here. Although most investors shouldn't expect to obtain returns over 14% over the long term, this graph clearly represents how important every percentage point is to the final portfolio value.
Benjamin and Gerald - How final rates of return end up mattering a lot in the long run
Finally, to really bring this home, let's go over one more example - this time let's look at two men. One is Benjamin and one is Gerald. Both Benjamin and Gerald invest $10,000 on the birth of their first child - this could be a college fund or a sort of "start of life" fund so that their progeny is financially stable. Clearly, both Benjamin and Gerald are intelligent, prudent, and caring individuals and parents - most people don't do such things. Another thing that's clear is that their children are quite lucky - they have dad's who care enough to put away some money for them at their birth. Both Benjamin and Gerald have $10,000 ready for this investment - they are quite similar in this and many respects. But, let's now see how they're different?
The strange thing is that Benjamin and Gerald are far more similar than different - in the thing that matter (caring, prudence, planning ahead, etc.), they are clearly quite similar. Their differences, as we'll see shortly, will be quite small and trivial if it wasn't for the outcome those differences would lead to.
Benjamin takes his $10,000 and invests it in a fund over the course of one year in a series of 24 purchases, once every month. He shops around for a good brokerage - the makes sure they're reputable and reliable but keeps an eye on trade pricing too. Benjamin chooses a long-term growth fund but looks at expense ratios, loads, and the quality of management in order to make sure that he's choosing the best fund for his strategy.
Gerald takes his $10,000 and invests it in 60 purchases because he is attempting to time the market. Gerald doesn't shop around for a brokerage and chooses the first one he finds. Gerald doesn't shop around for a fund, but instead takes a recommendation from his friend or family member - this fund has the same strategy as Benjamin's fund but isn't managed as well, has a load, and has a higher expense ratio.
Both Benjamin and Gerald leave the money in their account after the first year and never touch it again - they pass it down to their children who also are wise enough to leave it alone and let it grow.
Take a look at the tables above to see the actual numbers Benjamin and Gerald are dealing with. In effect, Benjamin and Gerald end up with different starting amounts and different return rates (9.75% vs. 7.25%) due to their different choices. These small differences made in the first year have tremendous impacts on the final portfolio values after 50 years. While Benjamin's portfolio is valued at over $1 million in 50 years, Gerald's is valued at only a bit above $300,000 - this is approximately a 70% difference. This 70% was a result of about a $600 difference in initial investment and a 2.5% difference in return. Most people would probably ignore these differences, but they are clearly extremely important.
If you're interested in further reading, below is a paper titled "The Arithmetic of Investment Expenses" by William F. Sharpe - a paper published by the same William Sharpe who created the famous Sharpe Ratio on how fees and expenses can impact the terminal value of a portfolio.
A stock is a share of ownership in a corporation - buying a stock means buying a piece of ownership in a corporation. However, there's more to know than just this..
Shares vs. Stocks - What's the difference?
If you want to speak properly, there's no such thing as stocks - there is the "capital stock" of a corporation and that capital stock is divided into "shares" that you can buy and own. Those shares represent little pieces of equity in the firm - they represent ownership of a small piece of the firm.
In popular usage, however, the term "stocks" are often used in place of "shares" - we can say that we own "stocks" instead of "shares." It's ok to use the term this way because most people will understand you and most people use it this way, although it's a good idea to understand the proper way the term should be used.
What does a share (or stock) represent
We said above that a share represents equity ownership in a corporation. What this means is that when you buy a share (or a stock), you are literally buying a piece of a corporation.
For example, if there are 1 million shares that are publically traded and you buy 1000 shares of the operation, you now own one-thousandth (1/1000th) of the corporation.
But, what do you actually own when you own shares of a corporation? You literally own piece of everything the corporation owns (eg. buildings, equipment, patents, copyrights, etc.) and you have an interest in the future income of the corporation - all relative to your ownership size (eg. if you own 1% of the shares you own 1% of the firm). If you owned a small business (eg. a small ice cream shop) in your neighborhood free and clear, you would own 100% of that shop - the same is true for a corporation except you will own a small percentage of it instead of owning it outright.
As the owner of the firm (as a shareholder), you are usually able to vote for certain things regarding firm decisions. The owners of the firm cannot run the firm by themselves (unlike the owner of a small business) so they appoint a board of directors who then hires managers (eg. CEO, CFO, COO, etc.) to run the day-to-day business of the corporation.
How does debt play into stock ownership?
As we said above, you literally own a piece of a corporation when you own a share of a firm, but that ownership is net of liabilities (debt) - that means that shareholders are second in line behind bondholders. If the corporation has no debt (if it's totally financed with equity), then there's no reason to even discuss debt at all. However, most corporations have significant amounts of debt (it's rational for corporations to use debt to finance various things), so we must take debt into account when calculating our ownership.
How can we take debt into account? We just do what you would do when calculating your net worth - we subtract liabilities from assets to come up with equity:
Once we figure out how much total equity is in a firm (the portion of assets financed through equity), we can divide that by the number of shares to determine the equity that corresponds to each share (this is somewhat of a simplification).
Additionally, as we stated above, we must keep in mind that debtholders hold senior claims to equity holders - that means that debts must be paid first before shareholders receive anything. Just like if you owned a house with a mortgage where the mortgage would have to be paid off first after you sold the house - the debt of corporation must be paid back before shareholders receive anything in a liquidation.
Assets > Financial Assets > Financial Derivatives
Another way to think of stocks is by understanding that they are financial assets. Real assets are things such as computers, desks, machines, and equipment while financial assets derive their value from these real assets. You can own real assets (eg. owning a computer or a piece of heavy equipment) but you can also have a claim on real assets through financial assets. A stock or share is a financial asset that gives the shareholder a claim on the real assets of a corporation and the income that those real assets produce.
Going a step further, we can have financial derivatives, which derive their value from financial assets. Financial derivatives such as options, futures, and forwards allow holders to have an interest in financial assets without actually holding financial assets.
5 Reasons You're a Terrible Investor - Why most people just can't seem to succeed at investing despite their efforts and wishes
Are you a typical investor? Research shows that the average investor in the United States significantly underperforms when compared to broad indexes such as the Dow Jones Industrial Average (Dow Jones) or the Standard and Poors 500 Index (S&P 500). Read the article below to find out the five main reasons for this disappointing phenomenon - and to make sure you don't fall into the same trap.
Too Many "Investors" are terrible at investing
Research shows that individual retail investors are not doing a good job at investing. Much research has come out showing that retail investors, on average, get much less than the overall market for the same level of assumed risk. This is ridiculous. This means that retail investors don't beat an index such as the Dow Jones Industrial Average (Dow Jones) or the Standard and Poors 500 Index (S&P 500). Instead, retail investors earn half of the return of the broad indexes on average.
If this doesn't surprise you, it should. How can the average investor earn half of a broad market equities index such as the Dow Jones or the S&P 500? Why wouldn't that "average" investor just invest in the index and get the index return? The reason must be because investors don't just invest in the index. They must do something else on average or else they would at least get the average index return minus trading fees and other incidental fees. Below are the five main reasons your or an average investor (hopefully you're an above average investor) fails to do well and fails to beat index returns.
1. You Trade too Often
The first reason that the average investor underperforms the market is because he or she trades too often. As we said above, if you just invest in the index you'll get the average index return minus any trading and incidental fees. There's a caveat there, however - you have to stay invested! You can't go in and out of positions consistently. By trading too often, you incur more fees and fees can really add up and eat away at your potential wealth.
For example, say an investor invests $750 a month in the stock market and the transaction fee is $7.50 (a reasonable amount at the time of the writing of this piece). That $7.50 will equal 1% of the investor's monthly investment, a non-trivial amount. If our hypothetical investor invests every single month and doesn't sell, he or she will have paid out $90 in fees. This is reasonable.
If, however, our investor is more erratic and buys and sells in a futile attempt to somehow time the market, he or she will pay a lot more in fees. Let's say the investor buys every week instead of every month, splitting his or her $750 monthly investment into $187.50 weekly investments. Additionally, our frantic investor also sells some amount every month. It doesn't matter how much he or she buys and sells in reality because most modern brokerage fees are usually flat (instead of a percentage of the invested amount). So, now we have the following costs:
Now, many investors don't invest $750 a month. Many invest more, but many invest less. Some investors can only invest $100, $200, or $300 a month. For them, the above situation would seem like a dream. For them, trading as often as the frenetic investor above would absolutely devastate their portfolio, requiring consistent extraordinary returns just to break even.
By trading too much, you put the breaks on your portfolio's growth. You might think you know what you are doing (eg. timing the market) or you might be scared of a downturn so you pull out for a while when the market dips, but all of that is incorrect for most investors as evidenced by their abysmally low performance as compared to a broad market index. For most investors, trading too much isn't a good an idea. They should stick with a good and suitable strategy and stay invested even if the market goes day. They should not be overconfident in their ability to predict price movements, understanding that there are thousands of well-trained, highly educated, and high-incentivized market participants attempting to do the exact same thing they are attempting to do.
2. You Hold Losing Positions too Long
Investors, by and large, tend to hold losing positions too long. Most top financial professionals and top investors seem to sell off losers quickly. Good investors are disciplined and are able to acknowledge losers when new information comes in.
I've experienced this desire to hold on to a losing stock in my own portfolio. I invested in a stock in an emerging market. My reasoning for investing in the stock was sound and many top financial professionals recommended purchasing equities in that specific market and of that specific firm. Two years later the position not only didn't move anywhere, but it had declined more than 10%. Things changed in the global economy - the country was doing poorly and exchange rates negatively impacted my investment. I didn't want to acknowledge the fact that I had chosen a loser because I bought the stock with a lot of conviction and spoke about my belief in the stock's future performance to others. However, I was disciplined enough to sell and free up the capital. I knew that the situation wasn't going to get better - it wasn't a momentary downturn in an otherwise great situation but was instead a structurally poor situation. the new information that had come in since I first entered into the position indicated that a prudent investor would exist and so I exited. It wasn't easy, but I'm glad I did it for two reasons. First, it freed up useful capital for investment into other stock. Second, it strengthed the "disciplined investor" muscle withing me by going against myself and forcing myself to do the prudent thing. I believe it will be easier (slightly easier) the next time a situation like this happens.
Why do investors tend to hold losing positions too long? That's a tough question to answer, but behavioral finance has attempted to answer it in recent years. It seems that investors only care about realized losses, not potential. Realized losses occur when you actually sell the position. When I sold my losing stock in the example above, the loss became realized. Investors generally seem to be fine with unrealized (or potential) losses because they are able to imagine the stock going back up. By selling the stock, they realize the loss and lose the opportunity for a price recovery. However, this is not a rational approach. Investments shouldn't be held because you can't stomach locking in your loss. Investments should be kept because they are still good investments and they are investments you would make today. whenever you're facing such a situation, ask yourself the following illuminating question: If I didn't own this stock (or any other type of investment), would I buy it today? If the answer is no, that's a good indication that you should sell it.
3. You Sell Winning Positions too Quickly
Investors typically hold on to losers too long, but they don't hold on to winners long enough. The average retail investor sells winners too quickly in an attempt to lock in the gains. It is possible that the same realized vs. unrealized phenomenon is at play here - investors prefer realized gains to unrealized gains. The problem is that selling to realize gains isn't a good reason to sell. Just as we discussed above, you should only sell a stock you own when it is no longer a good investment. You can ask yourself the same question we asked above: If I didn't own this stock, would I purchase it? If you would, then you shouldn't sell just because you made money with it. If you believe it's still a good investment and that it will rise in value, you should stay invested in it and you shouldn't sell it.
4. You're too Greedy
Greedy investors don't do well over the long term. Greedy investors buy and sell too often (Reason 1 above) and they often sell too quickly (Reason 3 above). Additionally, greedy investors get in at the wrong time and get out at the wrong time.
I'm sure you've heard of the popular investment saying: Buy low and sell high. Well, greedy investors often buy HIGH and sell LOW. They don't do it consciously, but they do it because they are unaware of what is driving their desire to enter or exit the markets. Greedy investors look at the market after a nice long bull run and ask themselves why they didn't get in earlier. Instead of rationally analyzing the current situation, they get in. Greedy investors take stock tips from people or get into speculative investments that have big upside potential but also a very big downside potential and where the chances of success aren't great. Great investors, however, try to find investments with big upsides but very little downsides (or no downsides at all - yes that might be possible).
When greed drives your actions there is little room for prudence and rationality to enter into the equation. You should attempt to keep calm in both bull markets and bear markets and do your best to objectively look at the situation. Additionally, it is important for you to keep in mind that quick money is very rare for the average investor because there are thousands of highly-trained, highly-educated, and highly-incentivized people in finance attempting to beat the markets. Do you think you can outdo them sitting at your computer at home or in your office? The answer is mostly likely "no" because you don't have a competitive advantage in this space. Instead, it is better to use your time and energy to play wherever you do have some sort of advantage. The desire for excellent returns and wealth is healthy, but greed is a destructive force both to your being and to your portfolio.
5. You're too Fearful
In the same vain as greed, fear also can be destructive to your portfolio. Fear can cause you to buy and sell too much (Reason 1 above). We said above that investors typically don't sell soon enough when they have poor-performing investments, but there are occasions where investors actually sell losing stocks too soon: panics.
During times of panic such as the Great Depression or the Great Recession (and even during less severe panics such as sharp market downturns and corrections), average investors seem to get scared and exit. This usually is a very bad idea, especially if you're diversified well. If you are diversified well and the entire stock market declined due to a major recession, everything is going to be down (correlations between asset returns usually go to one in times of panic). If everything is going down, that might mean that the situation isn't totally rational. There are some goods stocks and some bad stocks in almost every market - everything going down usually means that there's an irrational drop going on because of fear. If you sell, you're locking in the losses - something investors usually don't like to do but seem to do too often during great crises. A better strategy would be to hold it out and wait for a recovery. In addition to waiting for a recovery, great investors relish downturns and panics because they are able to buy more stocks at discounts - they buy the good companies that are down not because of the companies themselves but because everything is down due to a crisis.
You Can Become a Better Investor
What we can learn from the five reasons above is that most people and most investors:
Investing is one of the best ways to grow and preserve your wealth, but you shouldn't start investing unless you've done the 7 things below. Read the article below to find out how to create a proper foundation before you being investing.
1. Pay down your credit card debt before you start investing
Before you start investing, you must make sure to pay down your high-interest credit card debt. I'm not saying you have to be free from all debt here. For example, many people successfully invest with a mortgage and with student loans. There's a debate in the financial community regarding whether or not you should be totally free from all debt before investing. I am in the camp that believes that investing with some low-interest or asset-backed debt can actually be a reasonable financial plan. There's more to this analysis and we won't go into it in this piece, but it suffices to say that even if some debt is acceptable when beginning to invest, credit card debt is not.
Credit card debt is a terrible form of debt. It is debt for things you've already purchased or experienced and in most cases they can't be reliably sold off to pay off the debt. Additionally, most credit card debt is at a high interest rate (10% + on average). Credit card debt can be like a ball and chain on your leg as you attempt to run toward financial freedom and wealth - it won't allow you to go very far. You must remove the burden of high-interest credit card debt and vow to never take on such an insidious form of debt ever again before you being investing. Do not put any money in the stock market or any other market when you have an opportunity pay off your debt first. By paying off your credit tcard debt, you'll effectively be earning a return on your money equivalent to the credit card's interest rate.
2. Have an emergency fund in place before you start investing
Before you start investing, you must make sure you have a rainy day fund in place to protect you and your household from life's financial emergencies. An emergency fund will help you withstand life's storms and it will protect your soon-to-be wealth in the form of investments from liquidation should you need funds to take care of a financial emergency. Check out the links below to get one of the deepest looks at why you need an emergency fund and how you can build one up incredibly quickly.
3. Don't start investing until you have a proper structure of insurance in place for you and your family
Before you start investing, make sure you have the proper insurances in place to protect you and your family. Here is a non-exhaustive list of possible insurance policies:
You obviously don't have to purchase every policy above - purchase what you need in your current situation and adjust things as you move along in life and in your financial plan. If you're not capable of deciding which policies to purchase on your own, it is advisable to speak to someone who knows about these things. This could be a knowledge friend or a family member, but it might be wiser to speak to someone who would have a fiduciary responsibility such as a financial advisor or consultant.
4. Decide on whether to invest alone or to use some sort of financial fdvisor
After you've paid off your credit card debt, built up your emergency fund, and put proper insurance policies in place for your current financial and lifestyle situation, you must ask yourself the following question: Can I go it alone or do I need assistance?
Many people successfully invest alone, but many also fail miserably when investing on their own because they can't do one or both of the following importing things:
What this means is that if you want to be a successful investor you've got to have some basic knowledge about why things go up and down in price (both short term and long term). Additionally, you have to have the discipline and emotional control to not panic and not get greedy, two things which are poisonous to your financial future. If you don't think you are capable of both of the above, consider using the help of a financial advisor or a financial consultant (at least for a short period of time).
It's not easy to find a good financial advisor. There are a lot of salespeople or charlatans in finance, but there are also a lot of excellent, inteligent, and kind-heated people. The dififcult part is differentiaing between the two. Don't hesitate to interview your financial advisor and ask questions - it's your money they will help yu manage after all.
5. Take a Risk Tolerance Quiz before you start investing
Take any online quiz with a grain of salt, but I strongly suggest that you take a reliable online risk tolerance quiz to help you better understand your risk tolerance and your emotional capability to handle volatility within your portfolio. There are two well-know solid quizzes like this: one is from Rutgers University and the other is put out by Wells Fargo.
6. Think about what you're investing for
Before you start investing, think about what you are investing for. Are you investing to:
When you think about what you're investing for, you will get a picture of a very important concept called time horizon. Your investment time the horizon will help you determine the risks you can take in your portfolio - the longer the time horizon the riskier your portfolio can be because you will have more time to ride out the ups and down.
7. Give some money away, even if all you can give away is a tiny amount
Before you start investing, and once you have paid off your credit card debt, built up your rainy day fund, and put proper insurance policies in place, you should give some money away. You can give it to a non-profit organization like the Red Cross, to a person asking for money on the street, or to a friend or family member hat is in need. The fact that you're now ready and able to invest means that you're better off than most people on this big blue planet of ours. You should be thankful for this and that gratitude should compel you to do something nice for your fellow human beings, especially those who aren't as fortunate as you are. You don't have to give a lot, but it should be a meaningful amount of money for you. I promise that this action will warm your heart and it's likely that you'll keep on giving throughout your life.
P.S. Start investing with matching-style accounts like 401ks
P.S. Make sure to put your first investment dollars in accounts where you get a "free money" (eg. some sort of match). This is usually an employer-sponsored retirement account such as a 401k. With such a match you get immediate returns. For example, if you get a 100% match, it's like getting a 100% return on your money right away with no risk. You can't beat that.
Investing vs. Speculating: Understand the difference so that you aren't taking needless and fruitless risks with your financial portfolio
What is investing? An attempt at a definitive definition.
Here's our definition for what investing is:
Investing, in the financial sense of the word, is the deployment of capital (usually money) into the purchase of shares, purchase of assets, development of commercial ventures, or other financial schemes in order to obtain a return on that deployed capital with a reasonable expectation (grounded in some sort of reasonable analysis) that the risk-adjusted or expected return is positive.
That's a long and somewhat fluffy definition, but any definition that would cover the broad range of activities that could properly be classified as investing will be somewhat fluffy. Let's break down the main elements of that definition and discuss them briefly.
...the deployment of capital...
This means you use some sort of capital (usually money) to invest. Without using or committing capital, you're not really investing. You can invest your time and energy into things, but that wouldn't qualify as financial investing. You must deploy capital in some way for your activity to properly be called investing in the financial sense of the word.
...or other financial schemes...
Investing requires the deployment of capital in a specific way. It requires that the capital be used to either purchase shares of a firm (the firm can be publicly traded or privately held), purchase assets (purchasing gold, Bitcoin, fine rugs, or fine art might qualify as asset purchases), develop commercial ventures (start a business or develop a new office building), or to pursue some other type of financial scheme. It's not easy to make an exhaustive list of the other possible financial schemes because there are many possibilities. For example, a properly documented and agreed upon private loan to an acquaintance can qualify as an investment. The purchase of various derivatives products might qualify as an investment as well. Even the purchase of rare grapes for the purpose of creating a unique wine could qualify as an investment. It's impossible to describe every possibility here, of course, but this should give you a general understanding of what I mean by a financial scheme.
...in order to obtain a return...
Investing requires that the deployment of the funds is done to obtain some financial return. If no return is expected or desired, then the deployment of capital is more like a donation or a purchase depending on the circumstances. Financial investing requires that it is done for the purposes of growing your capital base by receiving a return on the invested funds.
Investing requires that we are reasonable in our expectations of the financial return from our endeavor. If we are unreasonable or foolish, it's not investing in my opinion. A reasonable person using reasonable analysis techniques (they don't have to be complicated, just sound and reasonable) should be able to agree that a positive return is possible. This means that if unfounded, biased, or inappropriate techniques of analysis are used in order to determine what the potential return is (either expected return), it is not investing in the proper sense of the word. For example, using deeply incorrect assumptions that you know don't make sense to calculate your expected return wouldn't hold up to this standard. You wouldn't be investing here, but would instead be fooling yourself and possibly speculating. Additionally, not dong any analysis whatsoever before deploying capital would preclude the activity from being called investing. The analysis doesn't have to be complicated (although deeper analysis is likely better), but some sort of thought must be given to what is occurring if we are to call the activity investing.
...that the risk-adjusted or expected return is positive.
This point speaks to how we calculate the return. We state that the return has to be positive, but we need to know how to calculate the return. In calculating the possible return, a more sophisticated investor should adjust for risk, calculating what is called the risk-adjusted return or the expected return (these two names can generally be used interchangeably in a non-academic or unsophisticated setting). There are complicated mathematical formulae for calculating risk-adjusted numbers, but what is meant here is something more basic: the return you expect to get should from your investment should be the adjusted for risk, with less probable outcomes discounted more intensely. In other words, the return can be thought of as a weighted average of the possible returns, each return weighted by its probability of occurrence. Going further, this means that investing requires that the expected return is positive. That expected return might never occur, but at the outset (when we deploy the capital) the expected return should be positive. No rational individual would deploy capital into a financial scheme that has a negative expected return.
Speculation isn't investing; neither is work or saving!
Investing, in the financial sense of the word, can be distinguished from other uses of capital or energy. Investing is not:
Keep the definition of investing in mind to avoid foolish speculative bets or to confuse saving with investing
In conclusion, we see that investing is a specific type of deployment of capital and is distinguished from work, saving, and speculation. Keeping the definition of investing in mind could help us differentiate between investing and speculation by applying the definition in a disciplined way before we deploy our capital. Investing is a fundamental part of individual wealth-building and it allows for a society to grow and prosper, but it should be done wisely and carefully so as to make sure that foolish bets are not being taken.
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).