in darkness, I see a starkness
a starkness unlike the one I knew before
in gloom, I see a boom
a boom unlike the one I knew before
in pain, I see a gain
a gain unlike the one I knew before
in fierceness, I see a nearness
a nearness unlike the one I knew before
in animals, I see a spirit
a spirit unlike the one I knew before
a spirit not frail nor afraid of hail
the kind that does not fail and will set sail
on waters fierce or dumb
by Pennies and Pounds
Written on May 8, 2017, this poem is under copyright and is the intellectual property of the creator of the poem and this website. Express permission is required to reproduce or distribute it - please email us at email@example.com for such approval.
In a job you sell your time and your energy for money - you will never become rich this way because of the inherent restrictions the laws of nature and of physics place upon us all. Entrepreneurship (eg. business, ideation, innovation, etc.) has been one of the few consistent and reasonably moral paths to both moderate and extreme wealth since the industrial revolution.
Of course, other paths such as crime and political corruption have always existed as paths to wealth for those who were willing to walk on them, but we are only concerned with paths that really add value to humanity and can at least be somewhat considered morally permissible.
No matter how hard you work and no matter how many hours you work, you will be restricted to the number of hours in a day, in a week, in a month, and in a year. With a job, you are selling your time for money. Your time might be worth little or it might be extremely valuable given your human capital, but you still are selling this finite resource for money.
The richest people in your towns and cities are generally not people who have jobs. Yes, someone in your city might earn $100,000 per year or maybe $250,000 per year working as a highly-paid individuals in a big corporation, but there are also plumbers, electricians, small accountants, small lawyers, dentists, doctors, programmers/coders, restaurant owners, website owners, that earn $500,000 or $1 million (or much more) per year through their entrepreneurial ability to use their human capital in a way that is not restricted by time. In effect, these entrepreneurs are able to expand the audience for whom they create value both in time and in scope - they can reach people even when they are not working (eg. website) and they can reach many more people (possibly millions) all by themselves. In this process, the create value for a lot of people and they are themselves able to extract a portion of that value as remuneration from themselves without having to rely on an intermediary in the form of an employer.
An Absurd Example of a Great Job to Bring the Point Home
There are 8760 hours in one year. Let's say you work like a crazy person and are able to work for 1/2 of that time. This means you work for 4380 hours in a year.
That 4380, represents about 84 hours per week without taking a single week of vacation. Clearly, we have an unsustainable situation if the work you're doing is in any way physically or mentally rigorous.
So, you -- a total workaholic per the above -- are making how much money? Well, that depends on your hourly wage. According to the Bureau of Labor Statistics (BLS), the average private sector hourly wage in early 2017 is $26.19. But you're not an average person - you're making a lot more than average in our example.
According to the BLS, the highest mean hourly in the US is for anesthesiologists who make about $130 per hour - this is even higher than surgeons, lawyers, doctors, and chief executives. But even then, let's say you make even more than that.
Let's say you can make $500 per hour consistently for every one of your hours. This is a hard thing to do. Lots of people earn $500 per hour for ad-hoc work - think of a graphic designer who bills for two hours after spending two hours securing a client or a lawyer's billable hours that don't take into account time spent on client interaction or business management. Unlike most, you're able to get paid $500 per hour for your entire 84 working hours every single week of the year.
So, per the above example, you'll make $42,000 per week
This comes out to $2.18 million per year
Clearly $2 million is a very large amount of money to be earning per year, but think of the fact that even with our truly absurd example where you're working like a machine and earning an extremely high hourly wage, you will still only earn about $20 million in 10 years or $100 million in 50 years. Yes, those are a large amount of money, but they are literally nothing when compared to what some top people in business and entrepreneurship make more than $100 million in a single year. Facebook founder and CEO Mark Zuckerberg, for example, has a current net worth that would equate to earning $4 million EVERY DAY OF HIS LIFE!
Clearly, the gains Zuckerberg and other extremely rich individuals have earned are not based on income - it would be impossible to sell their time to earn such gains. Instead, they have earned money selling other things such-such as ideas that are not restricted the same way time is. The highest paid salaried people are always making less than the highest paid entrepreneurs because the world is created in such a way that time is restricted while ideas are not - with ideas you can be earning multiple streams of income every second of every day or you might have windfall gains by creating immense value for millions (or even billions of people). It's far more difficult to do this at a so-called job.
The key takeaway here isn't that it's bad to have a job. The key takeaway should be that you have to lift your head up from the current place you’re at and see things in a broader, holistic, and realistic way. By understanding the inherent restriction, a job places on your ability to earn you might be better able to spot opportunities or even better understand the world.
Entrepreneurship isn't for everyone - many people will do better at a good job in a good firm. Additionally, although the above discussion was about money, money is not the most important thing in work and shouldn't even be the reason anyone forgoes a job to start a business on their own. There must be something else besides money motivating you if you are to have a chance at being successful in any endeavor.
The only thing we're trying to portray here is that business and entrepreneurship allows you to escape from the paradigm of selling your time for money - you can escape this paradigm and go beyond the limitations of time and space on value creation that a job places on you.
Caveats and Exceptions - There are Some Jobs That Will Make You Rich
As with almost anything that's generally true, there are some caveats and exceptions. Here, the main caveat is that there are in fact a handful of people in the world who do become truly wealthy through their jobs. These people include the likes of:
Additionally, one might argue that in the above absurd example it was unfair to bring in the likes of Mark Zuckerberg - there are plenty of entrepreneurs who earn less and even more who fail and don't earn much at all. This is all true, but the point did do a comparison of high paid jobs vs highly paid entrepreneurs. In that comparison what we attempted to illustrate this that in entrepreneurship there is inherently little restrictions on earnings - earnings can be so great that they become absurd (eg. $4 million a day for every day of Zuckerberg's life) while job earnings are restricted simply by the laws of nature and the laws of physics.
There have been 22 recessions since the turn of the 20th century -- see the table below for a list of all of them (sourced from here) -- and we have currently experienced one of the longest expansion in US history as of early 2017 - by June 2017 we will have experienced an 8-year expansion (almost 96 months) - this is the third longest bull market in over 100 years. Clearly at some point within the next 2 to 5 years, we're going to experience a recession.
This article isn't about 2017 or this latest bull market, however - it's about the economy in general and the fact that things so far have been cyclical. Given the last century of markets, we can safely assume things will continue more or less the same way unless deep structural changes cause some sort of change. These types of changes might be:
Until those things happen, a prudent person would assume a recession will occur when a bull market has been going on for a long time.
Can you predict when a recession will happen? NO.
Can you predict how bad the recession will be? NO.
BUT, can you reasonably assume there will be one? YES.
Now, why are we writing this piece? Doesn't it seem obvious? Well, in fact, there are generally two schools of thought in personal finance and investing when it comes to recessions - neither of which are healthy for most people to adopt:
What's a better option? The better way is to simply observe things in light of historical data and without trying to quantify things. In this observation, you need to be incredibly humble of your lack of ability to really predict much but you still need to be mindful of the length of bull market runs. As the run gets longer - as Year 1 turns into Year 5 and then turns into Year 8 of a bull market you will want to
Most people will sell during a recession - usually after having purchased at the previous highs in a euphoric frenzy. You, however, should be sitting calmly with a pile of cash ready to buy excellent stocks at very low prices. In the meantime, you'll still want to be investing - you don't want to stop investing and wait for a recession because you can't rally predict when it will come and you don't want to spend years sitting around waiting without getting any market returns.
Be wary of those individuals who try to predict things too much, in fact, add a lot of risk to the equality. The risk comes from the false assurance they provide themselves or others - it is better to wisely understand your total lack of knowledge about something than to confidently go forward when ou really don't understand something. As Mark Twain so eloquently stated: "It ain't what you don't know that kills you, it's what you know for sure that just ain't so."
Most people in history created their livelihood -- either by creating income or by actually producing the necessities of life with their own hand and toil -- within family or communal units. The idea of working at a job for a larger entity such as a corporation is extremely new in the grand swath of human history. In effect, almost all of the people who ever lived could in effect be classified as small business owners - this is even true today as most US employment comes still from sole proprietorships or small businesses.
Why is it useful to understand the history of work/labor?
This idea is very important to people living in modern societies because we have a view within our minds that is quite different from reality. Many people believe that:
Going beyond the present day and having at least a basic conception of the things our ancestors did to create substance and value in their ancient worlds will assist in opening up your mind to new opportunities, new ways of combining life with work, and new ways of creating value for others.
Hunting and Gathering - The First Sole Proprietorships
For most of our history, we hunted meat and gathered fruits and vegetables to feed our families and our very tight-knit communities. The lifestyle involved simply waking up with the sun, looking for food during the day, and resting in the evening. Bedtime was when it became dark and no hunter-gatherer had to plan very far ahead.
The first really interesting thing to think about when thinking about how hunter-gatherers provided for themselves is how there were almost never any intermediaries. Besides the possibility of occasional trade within tight-knit communities, hunter-gatherers had what can be considered a two-step method to getting what they wanted. In terms of purity of execution, this was the most basic/fundamental way of obtaining food and water - a hunter gather would literally expend energy in order to obtain the final product he/she sought.
The second interesting thing arises from the first - hunter-gatherers didn't create value for other human beings in order to achieve their goals. Of course, a hunter-gather might want to provide for his family and create value in that pursuit, but that's not what we mean here. What we mean is that hunter-gatherers either went to pick edible growings or killed animals in order to obtain sustenance. In that pursuit they did not serve any other human being in any way - they simply went out into the world and obtained what they needed from it. Contrast that with today's world where we almost exclusively have to earn our livings by creating value for other people, be they your employees or your customers (which are also your employers in a sense). We're not making a normative statement here - we're simply making a descriptive statement.
The third very interesting thing about thinking of the working hunter-gatherers performed is that they had a direct understanding of how their efforts and skills translated into the final product they obtained. Of course, hunter-gatherers likely had some sort of quasi-religious beliefs where they imbued objects, the weather, etc. with spiritualistic aspects and they might have relied on them to provide. However, that doesn't detract from the simple physics of hunting and gathering - every hunter-gatherer must have understood how it was their own physical efforts out in the world that were the proximate cause of their gain. They could have thought the ultimate cause came from the skies or from the tree spirits or elsewhere, but they surely understood that the proximate cause was their own effort - they surely understood that without themselves leaving their cave, picking growing, or killing an animal and dragging it home, their families would not have food to eat. Contrast that with today's modern corporate worker who works in a corporate office or campus and who has
These complex factors can include things such as
Yes, a person's well-being still depends on themselves and everyone must take responsibility for their lives - you must work hard and well so that you're able to do well in your job and in life. However, it is abundantly clear that the level of mental control that a person feels over his or her method of meeting wants/needs should have been far greater in the past than in today's complex and interconnected environment where so much of the economy is not visible or understandable by a single individual.
This understandability of relationship between soil and result could be psychologically beneficial to human beings on many levels. This isn't a psychology website and we're not purporting to have any theoretical or empirical underpinning for these statements, but it does seem to make sense that an individual who has a clear "a leads to b" understanding of the relationship between toil and result -- as opposed of "a to b to c to d to a BLACK BOX to e to f to g" understanding -- would have greater psychological comfort and less psychological stress.
In no way is above supposed to make you envy a hunter-gatherer - we live in a far richer world (both physically and mentally) than our ancestors and anyone who would want to give up today's peace, today's luxury, and today's comfort for a hungry dangerous life of basic subsistence and survival is a quite unusual person.
Agricultural Revolution and Farming
After many centuries of foraging, humans ended up farming. This happened gradually over the course of centuries as well, but the end result was the literal transformation of human life from a nomadic existence to a settled life that would be far more familiar to the modern person.
Although life transformed as well as the approach fro providing for it, humans still operated at a family or communal level - humans still remained in effect small business owners. The business changed, of course humans went from hunting and gathering to
Humans mainly operated as family units after the agricultural revolution according to current historical data with larger family-based communities existing for things that went beyond the family. In effect, each household ran a small farming business that employed the entire household from a relatively young age by today's standards.
Here people had a bit more complexity - their toil no longer immediately translated into value creation (eg. food to eat) but had to go through the intermediate step of waiting for the seeds to grow into plants. The same is true for livestock - farmers and heard had to wait for livestock to grow and spend time and energy on breeding instead of just going out into the wild to kill game.
We can see that from hunting and gathering to farming -- things which make up by far the vast majority of human existence -- we operated in very small-scale communities and were in effect creating our livelihoods within our family units. In effect, all hunter-gatherers and farmers until the Industrial Revolution turned farming into big business can be classified as small business owners in the very broad sense of the world. These individuals worked primarily for themselves and their families. Farmers in certain eras might have had to pay taxes to lords or barons or other elites, but these can be thought of as quasi-taxes. Almost all of humanity did not know the meaning of providing your labor (either in the form of physical or mental exertion) to another individual in return for some sort of payment - this was the case for many reasons, one of which was an economy that was so poor that it could not sustain such interactions in a meaningful way.
Artisans and Craftsmen - Sole Proprietors Throughout History
Beyond farming, there have been at times in history a class or artisans or craftsman. This class developed after the Agricultural Revolution as settled communities were needed in order for this class of people to arise. They mainly operated in larger cities and they ran what can be considered small businesses. The words "artisan" and "craftsman" is too narrow, however, as these individuals operated a large variety of business. These businesses including:
All of the above can also be classified as small businesses. They are more like the small businesses we think of today - instead of directly producing their own livelihoods, these artisans and craftsmen would set up shop and serve their communities. They would very likely have most of their family involved in the business and live either close by or directly above their shops.
The Modern Working World
Although the majority of US jobs still come from small businesses, most people think of work as something you do in a large-scale setting such as a corporation. Most people even aspire to such work.
This work is quite different than operating a small business because it involves providing your labor to a larger entity that you do not control and likely can never fully understand (not even the CEO of a large firm fully understand what's really going on). This creates a sort of "black box" effect where you provide your labor into a "black box" and then some income is given to you. You aren't totally sure about the actual value you're creating for the firm and you don't fully understand how your labor fits into the bigger puzzle.
There are of course many benefits working in jobs - most of these benefits come from a certain stability that is not always present in running a small business. However, there might be some psychological costs that affect a person in the following ways:
Working in a job might make a person blind to other small but very profitable opportunities where their skills might be used. They might not ever consider opening their own business, running their own website, consulting on their own, or providing value on a small scale. This is unfortunate because it is in such small setting where you are able to capture the full value of your efforts (instead of the employer capturing most of the value). This is really how people get rich today - most people will never get rich working for a job and saving a large portion of their income; the vast majority of people in our world get rich in entrepreneurial activities.
Some Examples of Employment Throughout History
Although most people worked for themselves throughout history, there were some interesting examples of employment throughout history. Here are a few:
You can't predict when a recession will hit, but you can be sure that a recession will come at some point. Speculation on the exact timing is a fool's proposition, but indicators exist to indicate when the overall market is overvalued and when a recession is more likely. Preparation for a recession is wise and simply ignoring overall market valuations will cause you to (1) not be ready to take advantage of investing opportunities a recession presents and (2) be potentially exposed in troubling ways due to improper diversification. The below 3 strategies are excellent ways to prepare for a recession.
1. Start Piling Away Cash for Cheap Stock Purchases When the Recession Hits
Cash is dry powder to investors and without some set aside you simply won't be able to take advantage of a recession. Cash will allow you to buy good stocks at deep discounts when the market falls during a recession.
Do you notice how the first thing we're advocating in terms of recession preparation is something that will allow you to buy more stocks instead of something that is meant to protect you? Obviously, you want to be protected in severely adverse market circumstances as an investor, but the most important thing about a recession isn't what it does to your portfolio in the short term, but the potential it has to boost your portfolio in the long term. A recession allows you to buy a lot of good quality companies at deep discounts - sometimes you see a price to earnings (P/E) ratios of indices such as the S&P 500 can drop below 10, indicating an extremely undervalued market overall.
Without having cash piled up ready to toss into good companies -- it's key that you only buy good companies -- you will miss out on potentially outsized gains due to inevitable market recoveries. The great thing about recessions is that you don't even have to pick individual stocks - something that is not recommended for novice investors or those with low-risk tolerances. Purchasing indexes (eg. S&P 500 or the Dow Jones) via broad mutual funds or ETFs will allow you to at once diversify and benefit from future recoveries. Purchasing the Dow Jones at the bottom of the 2007/2008 Great Recession would have created a 300% + return over the course of a decade without having to take on the risks of owning single stocks or having to put in the effort to pick them.
When the market seems overvalued in terms of market P/E ratios, in terms of timeframe since the last recession, or in terms of high-quality research/opinions, it might be a good idea to slightly pull back on some of the more speculative investing you're doing to put aside cash. You'll want enough cash so that you can comfortably enter positions at lows and then continue buying more and more if markets continue to drop. This abundance of cash will allow you not to think about timing the market -- something that you will not be able to do -- but will instead allow for an aggressive dollar cost averaging strategy once things start to decline until things start to turn up again.
2. Properly Diversify Your Portfolio so it Can Withstand a Recession
To make your portfolio more resilient to recession declines you'll want to diversify across:
You don't want to hold just US firm and you don't want to hold firms only in a single industry (eg. tech). Instead, you want to hold a broad portfolio of high-quality firms from around the world and from different industries. Some regions and industries will be more resilient than others and this will affect your portfolio. additionally, some firms will go bankrupt in recessions - hopefully, you don't own any such firms because you've done proper due diligence but some things are very hard to predict. You'll want to not be tied to a single industry, a single location, or a single firm when the market turns downward so that a single disastrous event will not affect more than a small portion of your portfolio and so that you can survive as an investor into the recovery.
A great way to diversify is through the use of mutual funds and ETFs, but diversification is also achievable through simply building your own high-quality stock for experienced investors - moderately experienced investors should not try this (novice investors shouldn't even think about this).
3. Buy Protective Puts on the Market (ONLY FOR ADVANCED INVESTORS)
If you don't know what a protective put is, this section is not for you at all and you should skip tot he end of the article.
If you do know what a protective put is but wouldn't be properly considered an advanced or experienced investor, you can read this section but you should not engage in this activity because it could cause a needless drain on your portfolio and a false sense of security.
If you're an advanced investor, you probably already know this strategy, but we'll remind you again. Protective puts are simply put options - they are called protective because of the context they are being used in. You can buy such protective puts on the overall market via market proxy (eg. S&P 500) in order to profit from market declines.
One way to execute such as strategy is to buy monthly out-of-the-money puts on the market proxy via a mutual fund or more likely an ETF. These should be out-of-the-money because what you're buying here is a form of insurance in case the market drops significantly - you're not trying to speculate. Out-of-the-money puts will be worthless if the market goes up or doesn't move much but will increase in value in a significant market decline. You can buy them for a reasonable term - monthly, quarterly, yearly but shorter repetitive purchases might be better because you're less exposed to the option's time decay.
If you're invested in the stock market -- be it with an individual portfolio, through an IRA, through a robot-advisor, or through a 401k -- you should know that markets will decline, economies will suffer, and your portfolio value will decrease. You can try to create a situation for yourself where you won't be exposed to the volatility of the markets, but the only real way to do this is to not be invested in equities at all - by entering the markets you're implicitly accepting a certain amount of short-term volatility that could cause you to see your portfolio drop by quite a bit. It's how you handle this drop that determines your resiliency as an investor and, in the long-run, that determines whether or not you're a successful investor.
Recessions Will Occur and Markets Will Decline
First, it's key that you understand that market will decline - you can't hide from this unless you're not invested in equities. If you only hold cash or fixed income securities (eg. bonds), you can safely ignore market prices on equities. In the case of cash, you don't care about the market either way. In the case of bonds -- although bonds can of course rise and fall in value based on credit worthiness and interest rates -you generally are more concerned with the ability of the borrower (eg. sovereign government, municipality, or firm) to pay as the agreed-upon schedule. If you hold stocks, however, you are exposed to two key factors:
Exiting the Stock Market at a Macroeconomic Downturn is One of the Greatest Mistakes an Investor Can Make
Imagine you own your house outright in 2007 and then in 2008 through 2010 the housing market starts to decline as it did in the US. Would you sell your paid-for house after seeing a drop in real estate prices of 30% or more? Clearly, that would be idiotic if you didn't need the money for something specific. Why, then, do so many investors feel so inclined to sell their stocks after a market drop? Just as with a paid-for house, you own your stocks outright unless you bought them on margin (highly unlikely for most retail investors).
Adding a mortgage on the house makes the situation riskier and it is, therefore, more understandable that you might need to sell your house in an economic downturn (eg. income loss). However, people are still far more inclined to sell losing stock positions in a macroeconomic downturn than they are to sell their mortgaged house. This doesn't make any rational sense and it represents a fundamental flaw in the way most people approach their portfolios.
Now, if something fundamental changes - meaning one of the following:
THEN you can be justified in existing a position. In this case, you'll be exiting, not because of a macroeconomic decline, but because of a macroeconomic change to your world of the stock you're holding.
In other circumstances, however, existing a previously good position is just foolish and will lead you to underperform the market over the long term. Additionally, you'll be effectively shooting yourself in the foot - you will be purposely selling off at the worst possible time instead of holding out a bit for a far better market scenario where a more fair value can be obtained for your investing.
Play Mind Games With Yourself to Prepare for the Inevitable Market Decline
One of the greatest ways to prepare for the inevitable market collapse (if you still think that this won't happen you need to go back and diligently study investing history before you proceed any further into the markets) is not use the same tactic elite athletes use to prepare themselves for competition - mental visualizations of game day with a focus on the desired outcome and the challenges that will likely be faced.
Elite athletes focus on the win, but they also visualize and understand the pain and the suffering that game day will likely entail. Instead of being optimistically naive, they in advance fully understand how difficult game day will be, they accept that difficulty fully, and they commit to persevering in spite of it.
Applying that same theory to your investing life you might want to visualise the goals you want to achieve (eg. the return you want to obtain over time or the number you want to hit in your portfolio) but you also will want to sit down and imagine how a 10% market drop will feel, how a 25% market drop will feel, and how a 50% market drop will feel.
Typically a 10% market decline will occur once every couple of years, a 25% market decline will occur once every decade or two, and a 50% market decline will occur up to a few times in your investing life. Failing to prepare for this almost inevitable circumstance could cause you to sell at a 50% market drop - clearly a very unpleasant outcome if waiting just a few years would allow you to recover all of your gains as has been shown via a study of US stock market history.
When you're playing these mind games with yourself it's key to really visualize the scenario and get that negative feeling in your gut you would get on the morning fo the crash. You will likely not have as intense emotions as you would actually staring at your dropped portfolio, but you should definitely feel that nasty feeling in your stomach. If no feeling accompanies this exercise you're doing it wrong and you should continue doing it over time until you really get that unpleasant gut feeling.
Once you have that gut feeling, let it wash over you and don't try to make it go away as humans tend to do with all emotions. Let the feelings stay with you and explore it a bit. See what that feeling is telling you to do. Realize how your emotions are ruling over you instead of anything rational - this is dangerous because investing is very unnatural to human beings and only rationality will help you do well. Tell yourself
It's important to not underestimate the power of such mental exercises. It's easy to dismiss this and argues that imagining things during a bull market won't help you when things really go bad and you actually are sitting in front of your broker's website looking at a number that is 50% less than it was yesterday. Of course, the two things aren't the same, but the power of visualizing is far greater than meets the eye at first. A lot of mental resilience to making foolish moves can be built up using the exercise above and be doing it once a quarter will over time create a healthy mental discipline against acting like a crazy person when things really go bad int he stock market.
The stock market has proven a great investment over the last century - investing prudently and in a disciplined way in the stock market would have yielded great results in every two-decade-long period in the US. This means that no matter where you start in the last 100 years (even a day before the collapse that started the Great Depression), if you invested wisely (meaning you diversified and dollar cost averaged into the market), you would have been far better off by investing in 20 years than you would have been holding the money in cash instead.
If this is the case, why are so many people so afraid of buying stock? Here are 3 reasons why:
1. You Don't Understand What a Stock Actually Represents
If you're afraid of investing in the stock market, you might simply not understand what a stock actually represents - you literally don't know what it is. Of course, you've heard of stocks and you know they are some sort of financial instrument or products, but if pressed you probably can't give even a basic definition that would clearly define what a stock is.
If you're in this camp of people, it does make a bit of sense that you're hesitant to invest in equities and delve into the stock market. People are often (and often rightly) afraid of what they don't understand - human nature keeps us safe by making us a bit frightened of the unknown. If you don't really know about something, how can you know if it's good or bad? Just as importantly, if you don't know about something, how can you know how to deal with it in productive and effective ways? Maybe it's better to just stay away from those things you don't know?
Staying away might be a good idea for some things in life, but it's a bad idea when it comes to delving into the equities market in your financial life - by not investing in companies around the world through the purchase of shares on the stock market, you are denying your financial self and your portfolio one of the best ways regular individuals can have a piece of the global financial pie and ride the wave of global growth over the long term. Without investing in stocks, you're not going to benefit when global GDP increases - you're going to have to rely either solely on your own labor income or a bit of interest income you'll earn by letting other people use your capital. Buying shares of good firms around the world, however, will allow you to literally have an ownership state in the global economy.
So, if you don't know anything about stocks today, it's time to learn. Fortunately, you're already ahead of many others because you're here reading this on this website - you've already taken a crucial first step. Next, you'll want to pursue around Pennies and Pounds a bit more in a free-form way to just get a feel of the kind of stock-related information that is out there. Once you've got a general conception, a book or two will prove quite useful in helping you delve deeper and learn more about personal finance and the stock market. Never underestimate the importance of learning about personal finance - your financial life is a key part of your overall life and not spending any time in studying up is as foolish as not going to school but expecting to do well in the job market.
2. You've Invested in the Stock Market in the Past, but You've Been Burned and Remain Scarred
Maybe you do know about stocks. Maybe you've even ventured out into the equities market in the past. And maybe you've been burned by it. Maybe you've
If the above happened to you, it's no surprise you're hesitant to go back into the stock market. You probably feel like
Although it's understandable that you feel this way, it's totally wrong - you're wrong if getting burned in the past has fundamentally created a negative outlook of the stock market for you. You got hurt in the past not because there are fundamental flaws in the stock market or that investing in stocks is simply not for you - you got burned because you made incorrect decisions.
Investing in stocks well requires a certain amount of basic knowledge. Things such as
If you got burned in the past in the stock market you probably bought a single stock or just a handful of stocks - this is foolish unless you're a Warren Buffet and for most people proper diversification is key. If you invested in Lehman Brothers or Pets.com or any other hot stock pic, you would have gotten burned - you invested without diversification and you invested in the wrong thing.
If you're going to stock pick, then make sure you pick the right stock. is not possible for most and, therefore, stock picking should be avoided like the plague. Instead, diversification via the use of mutual funds and exchange-traded funds (ETFs) should be utilized with a few stocks here and there if you're willing to take on the risk. Additionally, a robust (but not too robust) cash position (that is separate from your emergency fund) would provide liquidity and help reduce the overall volatility of your portfolio.
You also might have gotten burned because you invested at the wrong time (eg. the Dot Com Bubble or in 2006/7) and then sold at the wrong time instead of waiting for the market to recover. Instead, you should have:
Instead of going in at once, a dollar cost averaging approach where you invest a bit every month or every quarter allows for less risk because instead of investing at a single time, you can take advantage of market drops by having your money purchase more stocks, mutual funds, and ETFs. Additionally, you must be disciplined enough to not sell in a market panic - this is very hard and this is what kills most investors. You need to study the history of the stock market and keep that history in mind in order to temper the craziness that will arise in your mind when you see your portfolio going down. A good investor that is invested in a strong and diversified portfolio will not sell at a panic - this investor will understand how foolish it is to liquidate positions at a market drop and will instead keep disciplined and follow through with his or her investing strategy.
3. You've Heard too Many Stock Market Horror Stories
Maybe your dad or your uncle got burned investing in stocks. Maybe a high school teacher told you about her venture into the stock market and how horribly it turned out. Maybe your grandparents' told you stories of the Great Depression and how they only hold cash and bonds. Maybe you've watched one too many news episodes during the Great Recession. Maybe you grew up in a house where there was a lot of misunderstanding and fear about the stock market.
Whatever or whoever go this fear into your head - it's not rational. Stocks have created tremendous amounts of wealth for both rich people and middle-class people over the last century. The Great Depression, the Great Recession, Black Friday, the Dot Com Bust, and all of the other horrible things that happened in the financial markets would not affect an investor that was properly diversified and dollar cost averaging (instead of going all in at once). It's normal that hearing of other people's failures when investing in stocks would make you cautious, but it doesn't have to be that way - you can easily succeed in the stock market if you take a disciplined and prudent approach. More importantly, if you're going to really build wealth and not simply rely on your own income, the stock market is one of your best bets.
Although a tax return means you've given Uncle Sam an interest-free loan over the course of the year -- something that probably isn't the best thing to do if you're a mature adult who knows how to handle money -- it can be a financial boost for many individuals and family in the early part of the year. In a sense, you've been forced to save over the year (you can think of it as forced savings account) and now you are to decide what to do with that savings.
Don't make the mistake of thinking that your tax refund is some sort of windfall or a gift from the government or some sort of unexpected gift that you didn't earn - your tax refund is literally your own hard-earned money that you've been forced to pay the government over the course of the year. Keeping this in mind, you should treat your tax refund like you should treat all of your money: with care, planning, and prudence. Below are a few key things you can do with your tax refund to improve your financial situation and add a bit of financial peace to your life.
1. Start or Increase Your Emergency Fund
This is Number 1 on our list of things to do with your tax return because for most people a strong emergency fund is the single best first step then can take to securing a better financial life.
Those that have some sort of guaranteed income might not need a rainy day fund as much as everyone else because there is far less volatility in their monthly income - for the rest of the world an emergency fund stands in between you (and your family) and financial disaster, stress, and worry should something unpleasant happen (and in this life, something unpleasant usually does happen every once in a while).
Getting your emergency fund to a solid level (typically 3 to 6 months of living expenses) is usually even more important than paying back even high-interest debt. A person with a large amount of credit card debt and nothing in the bank at all clearly is exposed to a lot of suffering if he/she loses their source of income or if an unexpected event or emergency comes up. Of course paying down the debt is very important, but without an emergency fund, there is too much exposure to even the slightest financial emergency.
Without any money, a job loss, a flat tire, a leaky roof, prolonged sickness or any other of the many things that can go wrong, will lead to a lot of pain in your life. Having even $1000 in the bank will help shield you and having a full 3 to 6 months of living expenses in the bank will give you a very pleasant calm in knowing that you've got enough stashed away to make it through most financial emergencies.
If you don't have an emergency fund, a tax refund can be used to start one at your local bank - better yet putting that money into an online savings account where it's a bit harder to reach might be a better option.
2. Pay Down High-Interest Debt
If you already have a proper emergency fund in place, the next best thing to do with your tax refund is to pay down high-interest debt. Such high-interest debt can be credit cards, personal loans, consumer lines of credit, and car loans, etc. These all qualify as bad debt in most cases - things like student loans, mortgages, and business loans (although clearly undesirable) are better because they generally carry a lower interest rate (because they are backed by either tangible assets or are not-bankruptable) and are generally taken out for thins that increase in value over time. Paying down high-interest debt will save you money on interest, will strengthen your overall financial position, and will bring some peace into your financial life.
There are two options when paying down credit card debt:
Generally, either of the above will work and actually pay down debt aggressively is more important than which of the above methods you choose. However, you can decide how to approach paying down your debts based on your own understanding of your personality - if you're the kind of person that might need a momentum boost by seeing a credit card fully paid off, then maybe focusing on the smallest balance is better for you even though it's not the best approach from a purely mathematical standpoint.
3. Take Advantage of a Bank Bonus Offer
If you've already got your debt situation under control (meaning you don't have credit card debt or other high-interest debt as described above), then you might consider using your tax refund to get even more money via a bank offer where you get a bonus for opening up a savings account.
Online banks such as Capital One 360 and even brick-and-mortar banks such as Chase often offer bonuses for opening up a new savings account. The general gist of it is that if you deposit a certain amount of new money (eg. $10,000), you get a bonus.
One offer online was for a $200 bonus for a $10,000 deposit - this equates to an almost immediate guaranteed return of 2%. To get 2% in the markets you would have to expose your money to a bit of risk. To get 2% in a guaranteed way (like you're getting with this bonus) you would likely have to lock away your money (circa 2017) for a period of at least a couple of years. Clearly, an almost immediate 2% gain is quite lucrative a low-interest rate environment and taking advantage of such an offer could give you extra boos on top of your tax refund.
4. Open an IRA
If you don't have an Investment Retirement Account (IRA) or if you're not currently contributing the maximum amount allowed, opening an IRA could be a useful way to store your tax refund and it can help lower your tax burden next year (as long as your income during the year in which you're putting the money into the IRA at least is as much as your putting in). You might want to speak to your tax professional about the best way to approach it and if this is really a good idea for you, but for most people, an IRA can help lower taxable income and, thereby, lower the overall tax burden for next year.
5. Start a College Fund for Your Children
If your financial house is in good shape, it might be time to start thinking about college for your kids (or their financial future in general). Whether college is a few years away or whether you have a newborn, saving for college is always a prudent idea and it will greatly benefit both you and your children.
A good idea is to save the money in a place where it can be used for non-college expenses. The world is rapidly changing and if your child is very young, it is not easy to predict what the academic or occupational landscape will be like in 15 years - college might be drastically different and so might college expense. Therefore, it is prudent to save in a place where your hands won't be tied in terms of how to use the money and where you won't have severe penalties if you or your child chooses to use the money for non-academic expenses (eg. starting a business, paying for a wedding, buy a house, or whatever other hopefully useful endeavor he or she chooses to embark on).
Bill Miller is another excellent, but not someone as widely known as Benjamin Graham outside of financial circles. Miller spent 35 years at Legg Mason Capital - his last role at the asset management firm was as Chairman and Chief Investment Office (CIO).
During his time there, Miller was able to beat the S&P 500 (in after-fee returns) for 15 consecutive years (from 1991 to 2005). This spectacularly consistent and exceptional performance is considered highly improbable per well-known financially theory that says the market is efficient and that above-market returns will most likely arise to do chance.
If there is a 50-50 chance of beating the market (the S&P 500) on any given year (as the Efficient Market Hypothesis would lead us to believe), the chance of beating the market for 15 consecutive (eg. flipping heads 15 times in a row) is 0.0031%. Miller's approach, therefore, seems to be more than just pure luck and many investors believe that his deep value-oriented approach to picking stocks can consistently produce market-beating returns if applied in a disciplined and knowledgeable way.
Market Cap Less than 3X Free Cash Flow (FCF) for Next 5 Years
The first screen wants us to only allow those firms whose market capitalization is less than three times the total estimated free cash flow (FCF) over the next 5 years. Here we are clearly looking for undervalued firms in terms of earnings, but we're not looking at the typical price to earnings (P/E) ratio that most investors look at - Bill Miller is concerned not with profits but with free cash flow (FCF), an important measure that is much harder to manipulate than is profit by the firm's bookkeeper.
A firm can make a profit but lose cash. A firm can lose money but be raking in cash (this is the case with Amazon). The reason for this has to do with accounting principles and how they have to be applied for publicly-traded firms reporting their quarterly earnings. Without getting into the weeds here, the nature of financial reporting leads to quite unintuitive representations of things - profit on the books might not translate into real cash every quarter and losses might not really be as bad as they might sound if cash if rolling into the firm's bank accounts.
By eschewing profit nad focusing gon cash, Miller moves toward a more realistic and intuitive measure. By looking at those firms that have a market cap less than three times the esteemed free cash flow (FCF) over the next 5 years, we are effectively putting a maximum multiple over free cash flow (FCF) on the firm. This means that we expect the full market cap to be repaid within the next 5 years in free cash (not in profit). This is a powerful criterion that will leave relatively solid value plays in terms of free cash flow (FCF).
Price Earnings to Growth (PEG) Ratio Under 1.5
As with Peter Lynch and Phillip Fisher, Miller also focused on the P/E to Growth (PEG) ratio. However, unlike Lynch whose screen includes a filter to eliminate PEG ratios greater than 1 and Fisher whose screen only seeks to include PEG ratios between 0.1 and 0.5, Miller is more aggressive in terms of accepting a higher PEG ratio of 1.5.
In this screen, although a PEG of 1.5 still is reasonable, the PEG filter can best be understood as eliminating overly expensive items rather than being a hard screen for deep value plays. If that was the case, the PEG ratio would likely be lower - around 1 or less.
Long-Term Debt Ratio Below Industry Average
Finally, if we're looking at value plays in terms of market cap to free cash flow, we want to make sure that the deep value present isn't because the firm is over-levered - we want to make sure the firm isn't burdened by excessive debt as debt can be a killer both to the ability to effectively use the cash the firm generates and because it creates a lot of risks.
By looking at firms with debt ratios below the industry average, we can be sure that we are being conservative in our stock pick. Combined with a reasonable PEG ratio and a low market cap relative to estimate future free cash flow (FCF) over the next 5 years, we can paint a full picture of the firm as a reasonably conservative value play.
Philip Arthur Fisher is going to be on the fringe of investors' knowledge - only those that are truly serious and deep in investing and stock analysis will likely know this man's name in our era. Everyone should know his name, however, as Philip Fisher is one of the greatest investors of all time.
Starting his career after dropping out of Stanford in 1928 to work in a San Francisco bank. Think about how astonishing this is - the likes of Bill Gates, Steve Jobs, and other Silicon Valley wunderkinds would follow suit (likely without even knowing who Fisher was) half a century or more later.
Fisher's seminal work Common Stocks and Uncommon Profits is a foundational piece of investing theory and writing that was published in 1958 but has remained in publication ever since, demonstrating how relevant Fisher still is to this day.
Fisher's investing approach was focused on purchasing growth at incredible discounts. Let's take a look at what to screen for if you want to perform stock screening in a manner aligned with Philip Arthur Fisher's investing principles.
Increase in Year-over-Year (YoY) Sales Over Last 5 Years
Here we can already see that we are not going to be playing games with the typical price to earnings (P/E) ratios and similar metrics most investors focus on too much - Fisher isn't going to play in that field but will instead be looking at metrics that evince a strong and growing business.
Year over year sales growth simply means that the current year's sales are greater than last year's sales - we want to see such growth for the last 5 years. Seeing a dip (or even a plateauing) of sales indicates that the business model is either (1) quite mature, (2) is experiencing cyclical difficulties, or (3) the firm's management isn't doing a good job.
Clearly, 1 and 3 above are not good, but many investors would accept 2 and say that the sales decline is simply due to the business cycle or the general cyclicality that the firm's business is exposed to. By required year-over-year sales growth for 5 years, Fisher implicitly answers the investors by saying that if the business is capable of being affected by this type of cyclicity, it isn't the type of business we want to invest in - we want businesses that thrive in good time and do well in bad times (we want robust businesses that can thrive in almost any economic environment).
Price Earnings to Growth (PEG) Ratio Between 0.1 and 0.5
The P/E to Growth (PEG) ratio is simply the P/E divided by the earnings growth rate - it shows you how much you're paying relative to a firm's earnings growth.
In the piece on The Peter Lynch Stock Screen we looked at a PEG ratio of less than 1 - here we take that even further and require an almost astoundingly low PEG ratio between 0.1 and 0.5. We can see that Fisher's approach is to find not just deeply undervalued companies, but deeply undervalued companies in terms of the growth they are exhibiting. In effect, the key in Fisher's approach is to pay as little as possible for as much steady and reliable growth you can get.
Research and Development (R&D) as a Percent of Sales Greater than Industry
Again we are focusing on things that will demonstrate intense growth or growth potential. Research and development is a good indication of a firm's belief of its ability to innovate - generally speaking, if a firm invests in R&D it believes that the benefits derived from the initial capital outlays (eg. the returns) will be higher than other potential capital uses (eg. the opportunity cost) - if a firm invests in R&D, it generally means that they think they have an ability to innovate.
Additionally, successful R&D generally results in growth. Therefore, a firm that is heavily investing in research and development is more likely to be a firm that is either already growing at a strong pace or will do so down the line. By choosing those firms that have a higher research and development expense compared to sales than others in the industry, you have a greater chance to look at firms that are Horwitz and creating new and innovative products/services.
However, it is important to be aware that only looking at research and development expenses as a percentage of sales is far from sufficient - looking only at R&D can deeply mislead you if that's all you look at. For example, imagine a firm that has sales of $1 and R&D expenses of $10 - this firm would have a tremendous R&D budget compared to sales, but we can clearly see that this firm is doomed because it's sales are too low in absolute terms and its R&D is excessively high in relative terms.
Growth in Sales Greater than Growth in Research and Development (R&D) Expenses
Here we see Fisher again focusing on research and development - this time, however, we're focusing on R&D growth. We want R&D growth to be less than sales growth - this will help prevent the plant scenario ($1 sales vs. $10 R&D) discussed above because a growing R&D budget doesn't by itself mean that much. A growing R&D budget that is accompanied by growing sales, however, does mean a lot - sales growth even greater than R&D growth means even more because it implies that the R&D expenses are producing great returns and that the firm is ultimately becoming more efficient in terms of the percentage of sales required for R&D.
Peter Lynch is one of the greatest investors of all time - any investor (or anyone involved in the financial markets for that matter) likely has heard of Peter Lynch.
Lynch managed the Magellan Fund at Fidelity from 1977 to 1990 during which the funds assets under management grew from about $18 million to about $14 billion dollars - this is an increase of about 777x, meaning that $1000 invested in the Magellan Fund under Lynch's helm in 1977 would yield about $777,000 in 1990 - an absolutely astounding return that skyrocketed Lynch into the top echelon of investors not only in his generation but in the history of investing.
In case the above numbers aren't enough to convince you of Peter Lynch's investing genius, let's compare the Magellan Fund's performance from 1977 to 1990 with the performance of the Dow Jones Industrial Average over the same time period. The Dow Jones Industrial Average managed an increase of about 3x over the same period - $1000 invested in the Dow would yield a comparably paltry $3000 in 1990.
Clearly, any investor should at least be interested in the general methods employed by Peter Lynch. Although Lynch articulates some general principles regarding his investing philosophy in the now classic One Up on Wall Street, we will look at what can be called a Peter Lynch Stock Screen - a stock screen that generally uses his principals to screen the universe of potential stocks for a small number of potentially lucrative stock picks.
Price Earnings (P/E) Ratio Lower than Industry
The common price to earning (P/E) ratio is often used in stock screening and Peter Lynch was no stranger of this classic and often used metric. By screening for firms that have a lower P/E ratio than the industry, an investor can find potentially undervalued equities.
In order to perform this screen, one would first need to accurately identify the industry. It's key that the industry classification is not too broad - this will create a more accurate comparison. For example, a luxury car company such as BMW might be better grouped with other similar luxury firms (eg. Mercedes Benz, VW Group, etc.) instead of as part of the car industry as a whole (eg. Ford, GM, etc.).
Once an industry P/E ratio is identified all stocks that have a P/E ratio at or above it can be screen out. More conservative investors might even choose a slightly lower P/E in order to more aggressively target deep value plays.
Price Earnings to Growth (PEG) Ratio Less than 1
The Price Earnings to Growth (PEG) ratio is an excellent metric and is especially useful for high-growth firms. The ratio compares the P/E ratio to the growth of earnings per share (EPS) - clearly, firms that have earnings per share (EPS) growth might allow for greater accommodation of higher P/E ratios because you are paying for future growth.
A PEG ratio allows investors to take the P/E into full account by also looking at EPS - it's possible that a relatively high P/E will be viewed in a much better light when the PEG ratio is looked at.
A PEG ratio below one is a low PEG ratio - it can be said that "growth is being purchased cheaply" with a low PEG ratio.
Insider Buying to Selling Ratio Greater than 1.5
This is an interesting thing to look at and it gives us a glimpse into Peter Lynch's thinking. Who has more knowledge of the firm, random investors or insiders? Clearly, insider buying implies optimism about the future prospects of the firm - relying on this easy to see metric requires no real analysis or calculation and is simply based on an understanding of the nature of knowledge and human society.
Sequential stock screening involves reducing the universe of stocks to a manageable size. For example, sequential stock screening might involve reducing all US publicly-traded stock to 10 stocks for use in a portfolio by eliminating stocks, one by one, based on filtration criteria (usually with the most important criteria first.
Although there's no absolutely best way to perform sequential stock screening, using criteria articulated by the famous Benjamin Graham is both a good way to approach stock screening and an excellent way to better understand some fundamentals that this man (and his successful investing successors) feel are important.
Benjamin Graham -- Warren Buffet's professor and mentor at Columbia University and author of such foundational books in investing as Security Analysis and The Intelligent Investor -- had a stock-picking approach that fundamentally could be described as looking for deep value. He effectively advocated looking for those stocks that were pretty much sure bets but whose current prices were deeply undervalued. The main components of a Graham-style stock screen would consist of the following criteria when performing a stock screen.
Adequate Size - Avoid Overly Small Firms
Adequate size can mean different things for different investors and there's not a hard and fast rule that Graham articulated that we can apply in today's market, but an investor can do one of two things in order to screen for size:
Sufficiently Strong Financial Conditions
This is another slightly ambiguous criterion and can be interpreted in different ways - it can mean having enough cash or not having too much debt (eg. various leverage-related metrics). Things to look at can be:
Non-stop Dividend Payments for Last 20 Years
This is the heart of Graham-style investing - you're focusing on a company that has done well over a very long period of time in the investing world. This would remove:
No Losses for Last 7 Years
This is similar to the dividend requirement - it shows that the firm has been doing well for a significant period of time. Not having losses for the past 7 years (or however many years you might choose - 5 years, 10 years, etc.) will provide some sort of assurance over the quality, resiliency, and robustness of the businesses the firm is in.
As above, this filter will rule out companies where you can't actually observe profits or losses for the last 7 years or companies that haven't existed for at least 7 years.
Increase in Per-Share Earnings of at Least 33% in Last 10 Years
As with the above, this shows long-term stability of the firm's business model - you want to see that the business is at least keeping up with (or beating) inflation in terms of its profits.
Current Price Less than 1.5x Book Value
This is a deep-value filter - we're looking for first that that are trading at only 1.5x book value. Book value can be thought of as liquidation value - book value is different from the market value in that it literally show the value on the "books" of the firm. This filter tells us that we want to buy firms whose market value is only 1.5x the firm's book value - this usually means the firm is reasonably valued.
To compare the 1.5x market to book value we're looking at here and to better understand it in the context of the overall market, let's look at the market to book value of the S&P 500. As of late 2016, the price to book of the S&P 500 was right around 3x, meaning the overall S&P 500 was trading at a price three times higher than the combined book value of all firms that comprise the S&P 500. Near the Dot Com Bubble the price to book of the S&P was about 5x.
Current Assets Worth at Least 1.5x Current Liabilities
This is a classic leverage filter where you look at whether your current assets are sufficient to provide current liability coverage if necessary. The world "current" in finance (for both assets and liabilities) generally means that one year or less - so current liabilities are liabilities (eg. debts) that can reasonably be expected to need to be repaid within one year.
This filter prevents a very unpleasant situation where an otherwise profitable firm might possibly be forced to liquidate productive assets or be forced into bankruptcy due to an inability to cover short-term debts due to adverse economic conditions or a change in the business cycle.
It's important to note, however, that not all of the above criteria have to be used - Benjamin Graham didn't articulate a particular sequential screening strategy but instead articulated principles that are represented in the above filters.
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 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 soldi 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:
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