Introduction
This guide is meant to give the average person a roadmap for investing. It will teach you the principles and attitudes necessary for wise investing, which are appropriate regardless of the year or the financial climate. This is not a “get rich quick” guidebook. Indeed, there is no guaranteed path on Wall Street. But you can use this guide to avoid the biggest errors in investing. Anyone can be an investor, but that doesn’t mean investing wisely is easy. Learn- ing the ropes requires discipline and curiosity. Apply yourself and stick to the fol- lowing principles in order to become an intelligent investor with a secure future.
Investment versus Speculation
A common mistake among investors is confusing investments with speculations. An investment is a transaction that, after thorough analysis, you are confident will return your principal plus a decent profit. Industry jargon labels any transaction in the stock market as an investment and any person actively participating in the market as an investor, but this is simply not true. Attempts to guess the rise and fall of the market are simply speculations. Never confuse outright speculations with investments. If you want to speculate for fun, set aside a fund to do so, but make sure it’s an amount of money you can stand to lose. Do not mix your investment money with your speculation money. An intelligent investor understands the risks of speculating and thoroughly ana- lyzes all transactions to ensure that they are true investments.
The Investor and Inflation
Inflation can decrease the purchasing power of any money you earn. Traditionally, stocks can withstand inflation better than bonds, leading many to believe that they should solely invest in stocks. But nothing in investing is completely sure. Everything fluctuates, and it is impossible to completely predict the future. Thus, diversification is always a better choice than relying on a single type of security. When protecting yourself from inflation, there are two great options for invest- ment diversification. The first is real estate investment trusts, or REITs. These companies own properties, collect rent, and do a great job of withstanding infla- tion. The other option is treasury inflation-protected securities, or TIPS. These are government bonds that automatically scale with inflation. Above all, the intelligent investor diversifies. No single security is always the best option.
A Century of Stock Market History
In the 1990s, investment experts assured the American public that stocks would al- ways be more profitable than bonds based on numbers from previous decades. Many people took this advance wholeheartedly, seeking out stocks at outrageous prices. By 2002, most of those stocks had plummeted. No one can completely predict the future based on the past. Just because some- thing has happened before — even if it has happened several times — there is no guarantee that it will happen again. The intelligent investor buys when the market is low and sells when it is high. The best strategy is to go against the flow: Assume the worst when everyone else is rejoicing, but stay positive when others are fearing the worst. The only sure thing about the market is that it will surprise you.
General Portfolio Policy
There are two kinds of intelligent investors: enterprising and defensive. An enterprising investor has the time and energy to build their own portfolio from scratch and constantly update it, while a defensive investor creates a stable and steady portfolio that performs automatically. Either approach can be done well, but you must understand yourself and know which category best fits your personality and emotions. If you are a defensive investor, you must make the decision about where to allo- cate your money up front. If you can responsibly take risks, allocate up to 75% of your investment into stocks, leaving the remaining 25% in bonds. If you don’t want that much risk, then do the reverse, or go somewhere in the middle. Once you have decided the percentages that you will allocate to stocks and bonds, the key is to leave your portfolio alone unless something major changes in your life, increasing or reducing your ability to take risks. To maintain your current allocations, you will need to rebalance your portfolio periodically. For example, if you have 70% of your assets in stocks and 30% in bonds but the stock market rises, you will then sell some of your stocks to keep
your number at 70%. This also ensures that you are selling high and buying low — one of the major keys to intelligent investing.
The Defensive Investor and Common Stocks
Even the most defensive investor should buy stocks. The key is doing your home- work to find the right stocks. Don’t take a company’s success for granted just because you are familiar with it — Study the financials and estimate the value of stocks before you buy them. Once you’ve done your homework, you can rest easy with an automated port- folio that allocates a bit of your investment into predetermined stocks each month. There are plenty of online brokerages that do just that. Mutual funds and index funds are the defensive investor’s best friend because they provide diversification without the maintenance. As a defensive investor, your most powerful weapon is your inaction. Put a fixed dollar amount into your portfolio regularly and forget about trying to guess what the market is doing.
Portfolio Policy for the Enterprising Investor: Negative Approach
If you want to take a more enterprising approach to investing — one that doesn’t rely on an automated portfolio — you must be wary of some major pitfalls com- mon among aggressive investors. The biggest mistake aggressive investors make is buying and selling quickly. In fact, this isn’t investing at all: It’s speculating. This method generally leads to overexcited investors buying overvalued stock or fearful investors selling stock that has dropped — the exact opposite of what you should do. Additionally, stock that isn’t held for a decent amount of time is taxed as income rather than capital-gains. That higher tax rate, plus the constant transaction fees, mean you need to gain a big chunk back just to recoup your initial investment. Steer clear of initial public offerings and junk bonds, both of which can offer high yields but also pose higher risks. They both tend to underperform. There is a lot to be gained from being an enterprising investor, as long as you take care to avoid the most common mistakes of investing.
Portfolio Policy for the Enterprising Investor: The Positive Side
You cannot accurately predict the financial market, and anyone who claims to do so is lying, pure and simple. Instead of trying to guess what the market will do next, follow a few tried and true strategies for investing. When it comes to growth stocks — stocks from companies whose earnings are expected to increase rapidly — remember that the bigger a company gets, the slow- er it grows. Infinite, massive growth is impossible. Buy growth stocks only when their prices are reasonable, and remember to take advantage when things go downhill. Temporary unpopularity can be a great oppor- tunity to buy in at dirt-cheap prices. When it comes to common stocks, remember that diversity is key. You never want all your eggs in one basket. While some of America’s richest investors have made their fortune by concentrating on a single industry, this is also a common way to lose everything. Buying foreign stock is a great way to diversify your portfolio because their mar- kets won’t necessarily follow the same patterns as the market in the United States. If the DOW tanks, your foreign funds may be your saving grace.
The Investor and Market Fluctuations
While most people would never make their life choices based on the mood swings of an unstable individual, investors tend to do just that with their financial choices. They buy high and sell low because they are following the market instead of think- ing critically. The intelligent investor must realize that the market is simply deciding the prices of securities, and it is up to the investor himself to choose whether or not to buy. You can’t control the market, but you can control the fees you pay, the risks you take, your tax bills, and your own choices. The best strategy for the intelligent in- vestor is to automatically contribute to an index fund each month. This is known as dollar-cost averaging. If you are investing in the future, the temporary highs and lows of the market don’t matter in the long run. Your commitment to steadfast investing and control- ling your emotions will make all the difference.
Investing in Investment Funds
Mutual funds are popular because they are cheap, convenient, diversified, and pro- fessionally managed. But these funds are far from perfect. Many mutual fund managers try to predict the market, which already know is un- wise. Additionally, many mutual funds come with excessive trading fees and higher tax costs because the managers trade frequently. A better alternative for the intelligent investor is an index fund. While regular mu- tual funds own certain securities based on the manager’s decisions, index funds hold all of the securities in a certain market. For example, the S&P 500 is an index of the 500 largest publicly traded companies in America, and an index fund in the S&P 500 would hold a security from each of these companies, regardless of the ups and downs of their individual performances. Index funds have extremely low fees and attempt to stay on track with the market instead of beating it. Index funds work when the intelligent investor holds them for a long period of time. There will be ups and downs — which the investor should ignore — but over the long haul these funds outperform regular mutual funds.
The Investor and His Advisers
Individual investors are perfectly capable of doing the work of researching and in- vesting on their own, but some people feel better having a professional take the reins. This is fine, as long as you do your due diligence when hiring a financial ad- viser. Not all advisers are created equal. Do some research to make sure any potential adviser doesn’t have any com- plaints or disciplinary actions on their record. Consult the US Securities and Ex- change Commission as well as your state’s securities commissioner. Don’t feel pressured to settle for the first adviser you meet with. The one you choose should care about helping clients, have a thorough understanding of in- vestment principles, and have adequate training and experience. The best advisers should ask you questions regarding your goals and budget. If they don’t seem interested in getting to know your particular situation, they are like- ly just in it for the money.
Security Analysis for the Lay Investor: General Approach
Not all stocks are created equal. Which factors should an intelligent investor con- sider when deciding how much a particular stock should cost? First, download several years of annual reports for each company. These are available on the EDGAR database of the SEC website. The companies that are worth a lot should show steady, not erratic, growth over the last decade. Judge a company based on their management. Did the leaders follow through with forecasts from previous annual reports? Did they acknowledge mistakes and improve? Leadership decisions should be consistent and accounting practices transparent. The biggest sign that a company’s stock is worth your money is simply this: They earn more than they spend. When reading annual reports, pay close attention to statements of cash flow. A company’s debt shouldn’t exceed 50% of their total capital. Doing your research ensures that you, as an intelligent investor, don’t overpay for stocks.
Things to Consider About Per-Share Earnings
One of the best pieces of advice any intelligent investor should follow is to disre- gard the short-term earnings of any company and focus on long-term stability and growth. If you do choose to consider the short-term earnings, then at least be on guard for some tricky strategies that can easily mislead the uninformed investor. Count- less companies have manipulated accounting principles in order to make their forecasts more favorable than they had any right to be. Pro forma earnings are one such manipulation. Originally, this practice was meant to give a better picture of long-term growth by eliminating certain costs from consideration. The idea was that eliminating one-off, nonrecurring costs would give a better overall picture of the company’s growth. But, companies soon took advantage of this practice and gave projections without considering very impactful costs. The intelligent investor should simply ignore pro forma earnings. Other companies also use aggressive revenue recognition: reporting earnings that haven’t actually occurred yet and may never actually happen. Still others treat regular operational expenses as capital expenditures, which are actually the costs of buying fixed assets that generate future business such as land or equipment.
Interchanging these types of expenses inflates the profit margin by hiding the fact that a company is spending lots of money. There are other tricks hidden in financial reports, and it is up to the intelligent in- vestor to dig deep before buying stock. Enterprising investors who plan to build their own portfolios from scratch must become familiar with financial reporting in order to make the wisest decisions.
Stock Selection
Choosing individual stocks isn’t necessary, nor is it usually very effective. Gener- ally, you could do better by simply buying a low-cost index fund, contributing regu- larly, and leaving it alone. This is a low-maintenance strategy that awards healthy returns. If you are committed to doing it yourself, it’s wise to practice first by tracking stocks without actually buying any and measuring your progress. Would you have done better had your money simply been in an index fund like the S&P 500? If so, you have your answer. If, after practicing, if you’ve discovered that you enjoy the process and actually did well, then begin assembling your portfolio. It is still highly suggested that you keep the majority of your money in an index fund, however. When choosing those extra stocks, use some specific criteria. Only buy stock from companies whose assets are at least double their liabilities. Companies should show at steady, continual growth and have clear financial statements. Avoid companies that have a plethora of nonrecurring or unusual costs. Whether you are a defensive or enterprising investor, you must still do your due diligence. Consult the EDGAR database from the SEC and read financial reports
from at least the past five years before buying stock from any company.
Convertible Issues and Warrants
Convertible bonds are bonds that behave more like stocks. Those who own con- vertible bonds have the option of exchanging them for stock in the issuing com- pany. These bonds can give investors stock-like returns without as much risk, but they are more risky and less profitable than regular bonds. Convertible bonds are protected from immense losses, but they also put a cap on potential gains. They can only do so well before the issuing company forces you to exchange them for regular stock. It’s better, and simpler, just to diversify your investments across regular bonds and stocks.
Shareholders and Managements: Dividend Policy
It’s important to remember that buying stock in a company makes you one of the owners. But, most stockholders are far more concerned with buying or selling stock than actually acting as a conscientious owner. Being an intelligent investor means being an intelligent owner. It is up to you to do the research and decide if company leadership is doing the work to ensure that outside shareholders are getting what they deserve. Publicly traded companies are required to supply their shareholders with proxy materials, which give vital information regarding company processes, dividend payouts, executive compensation, and outstanding shares. Responsible investors should read the proxy materials carefully and vote conscientiously at shareholder meetings. If you ignore proxy materials and neglect your shareholder vote, you have no right to be angry if the company does poorly. It is up to you to monitor the behav- ior of corporate managers whose decisions affect your wallet.
‘Margin of Safety’ as the Central Concept of Investment
The idea of investing goes hand in hand with risk. Those who take the biggest risks may experience big wins, but they almost always experience huge losses, too. One major loss can take years and years to recoup. Is it worth it? Some loss is inevitable in investing, but the intelligent investor takes care not to lose the majority of their money. The best margin of safety is to refuse to pay too much for any investment. Even the best investor is still human. Your analysis will be incorrect at some point in your life. Don’t take a risk if you can’t afford to deal with the consequences of an incorrect analysis. Once again, the most intelligent way to invest is to keep your assets diversified, regularly contribute, and ignore the mood swings of the market. Buy low and sell high. With this strategy, you will be able to withstand mistakes. Your investments will be safe from both yourself and the market.
Conclusion
To succeed as an intelligent investor, your goal should be to manage risk rather than avoid it. The truth is, risk and uncertainty are simply part of the package with investing. But if you follow the roadmap for intelligent investing, the gamble is exciting in- stead of terrifying. Take only the risks you can afford, diversify your investments, and forget about trying to predict the market. These tools will make you an intelligent investor who is confident and excited for the future.
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