The classic board game Othello carries the tagline “A minute to learn... a lifetime to master.” That single sentence could apply to the task of choosing your investments. Understanding the basics doesn't take long, but mastering the nuances can take a lifetime.
Here are some basic concepts any investor should understand if they want to improve the effectiveness of their investment selection.
- Commit to a timeline. Give your money time to grow and compound.
- Determine your risk tolerance, then pick the types of investments that match it.
- Learn the 5 key facts of stock-picking: dividends, P/E ratio, beta, EPS, and historical returns.
The 80/20 Rule
The Pareto Principle is a helpful concept to keep in mind when starting a task that encompasses a vast amount of information, such as the topic "how to pick your investments." In many aspects of life and learning, 80% of the results come from 20% of the effort. This principle, named after economist Vilfredo Pareto, is often called the “80/20 rule.”
We’ll follow this rule and focus on the core ideas and measurements that represent the majority of sound investment practices.
Know Your Timeline
You need to commit to a period of time during which you will leave those investments untouched. A reasonable rate of return can be expected only with a long-term horizon.
When investments have a long time to appreciate, they’re more likely to weather the inevitable ups and downs of the equities market.
It may be possible to generate a return in the short term, but it's not probable. As legendary investor Warren Buffett says, “you can't produce a baby in one month by getting nine women pregnant.”
The Magic of Compounding
Another important reason to leave your investments untouched for several years is to take advantage of compounding.
When people cite “the snowball effect,” they’re talking about the power of compounding. When you start earning money on the money your investments have already earned, you’re experiencing compound growth.
This is why people who start the investing game earlier in life can vastly outperform late starters. They get the benefit of compounding growth over a longer period of time.
Choose the Right Asset Classes
Asset allocation means putting your investment capital into several types of investments, each representing a percentage of the whole. Allocating assets into different classes that are not highly correlated in their price action can be a highly effective way of diversifying risk.
For example, you might put half your money in stocks and the other half in bonds. If you want to diversify your portfolio further, you might expand beyond those two classes and include real estate investment trusts (REITs), commodities, forex, or international stocks.
To know the right allocation strategy for you, you need to understand your tolerance for risk. If temporary losses keep you awake at night, concentrate on lower-risk options like bonds. If you can weather setbacks in the pursuit of aggressive long-term growth, go for stocks.
Neither is an all-or-nothing decision. Even the most cautious investor should mix in a few blue-chip stocks or a stock index fund, knowing that those safe bonds will offset any losses. And even the most fearless investor should add some bonds to cushion a precipitous drop.
The Rewards of Diversification
Choosing among various asset classes doesn't just manage risk. Greater rewards come from diversification.
Nobel Prize-winning economist Harry Markowitz referred to this reward as “the only free lunch in finance.” You will earn more if you diversify your portfolio.
Here’s an example of what Markowitz meant: An investment of $100 in the S&P 500 in 1970 would have grown to $7,771 by the close of 2013. Investing the same amount over the same period in commodities (such as the benchmark S&P GSCI Index) would have made your money grow to $4,829.
Now, imagine you adopt both strategies. If you had invested $50 in the S&P 500 and the other $50 in the S&P GSCI, your total investment would have grown to $9,457 over the same period. This means your return would have surpassed the S&P 500-only portfolio by 20% and be almost double that of the S&P GSCI performance.
A blended approach works better.
Traditional and Alternative Assets
Most financial professionals divide all investments broadly into two categories, traditional assets and alternative assets.
- Traditional assets include stocks, bonds, and cash. Cash is money in the bank, including savings accounts and certificates of deposit.
- Alternative assets are everything else, including commodities, real estate, foreign currency, art, collectibles, derivatives, venture capital, special insurance products, and private equity.
Most individual investors will find that a combination of stocks and bonds, plus a cash cushion, is ideal. Everything else takes highly specialized knowledge. If you're an expert on antique Chinese porcelains, go for it. If you're not, you're better off sticking with the basics.
Balancing Stocks and Bonds
If most investors can reach their goals with a combination of stocks and bonds, then the ultimate question is, how much of each class should they pick? Let history be a guide.
If a higher return is your goal, and you can tolerate the higher risk, mostly stocks are the way to go. The fact is, the total return on stocks historically has been much higher than for all other asset classes.
In his book Stocks for the Long Run, author Jeremy Siegel makes a powerful case for designing a portfolio consisting primarily of stocks.
His rationale: “Over the 210 years I have examined stock returns, the real return on a broadly diversified portfolio of stocks has averaged 6.6% per year,” Siegel says.
A risk-averse investor may be uncomfortable with even short-term volatility and choose the relative safety of bonds, but the return will be lower. “At the end of 2012, the yield on nominal bonds was about 2%," Siegel notes. "The only way that bonds could generate a 7.8% real return is if the consumer price index fell by nearly 6% per year over the next 30 years. Yet a deflation of this magnitude has never been sustained by any country in world history.”
Cash Is Not an Option
Whatever mix choose, make sure that you make a choice. Hoarding cash is not an option for investors because inflation erodes the real value of cash. Case in point: At a rate of 3% inflation per year, $100,000 will be worth just $40,000 in 30 years.
Your age is as relevant as your personality. As you get closer to retirement, you should take fewer risks that could jeopardize your account balance just when you need it.
Some people choose their stock/bond balance by using the “120 rule.” The idea is simple: Subtract your age from 120. The resulting number is the portion of the money you place in stocks. The rest goes into bonds. Therefore, a 40-year-old would invest 80% in stocks and 20% in bonds. Ten years later, the same person should have 70% in stocks and 30% in bonds.
How to Pick Stocks
Now that we can see that stocks offer higher long-term appreciation than bonds, let's look at the factors an investor needs to consider when evaluating stocks.
The real spending power of $100,000 after 30 years of 3% inflation.
In keeping with the Pareto Principle, we’ll consider the five most important aspects. They are dividends, P/E ratio, historical return, beta and earnings per share (EPS).
Dividends are a powerful way to boost your earnings. The frequency and amount of the dividend are subject to the company’s discretion and they are largely driven by the company's financial performance. More established companies typically pay dividends.
And dividends are a serious driver of wealth. Going back to 1960, 82% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding, according to a Hartford Funds white paper.
In addition, dividend payments are a sign of a healthy company.
A price-earnings ratio is the company's current share price compared to its earnings per share. A P/E ratio of 15, for example, tells us that investors are willing to pay $15 for every $1 of earnings the business earns over one year.
The P/E ratio is the most commonly used measure of a stock’s relative value.
A high P/E ratio indicates that investors have greater expectations for a company. Those expectations may be unrealistic because investors are handing over more money in anticipation of future earnings--even though they cannot expect to know the future outcomes for the company.
A low P/E ratio may indicate that a company is undervalued, or that investors expect the company to face more difficult times ahead.
What is the ideal P/E ratio? There’s no perfect number. However, investors can use the average P/E ratio of other companies in the same industry to form a baseline. For example, the average P/E ratio in the healthcare products industry is 161. The average in the auto and truck industry is just 15.
A stock’s P/E ratio is easy to find on most financial reporting websites.
This number indicates the volatility of a stock in comparison to the market as a whole. A security with a beta of 1 will exhibit volatility that’s identical to that of the market. Any stock with a beta of below 1 is theoretically less volatile than the market. A stock with a beta of above 1 is theoretically more volatile than the market.
For example, a security with a beta of 1.3 is 30% more volatile than the market. If the S&P 500 rises 5%, a stock with a beta of 1.3 can be expected to rise by 8%.
Beta is a good measurement to use if you want to own stocks but also want to mitigate the effect of market swings.
Earnings Per Share (EPS)
EPS is a dollar figure representing the portion of a company’s earnings, after taxes and preferred stock dividends, that is allocated to each share of common stock.
Investors can use this number to gauge how well a company can deliver value to shareholders. A higher EPS begets higher share prices. The number is particularly useful in comparison to a company's earnings estimates. If a company regularly fails to deliver on earnings forecasts, an investor may want to reconsider purchasing the stock.
The calculation is simple. If a company has a net income of $40 million and pays $4 million in dividends, then the remaining sum of $36 million is divided by the number of shares outstanding. If there are 20 million shares outstanding, the EPS is $1.80 ($36M / 20M shares outstanding).
Investors often get interested in a stock after reading headlines about its phenomenal performance. Just remember, that's yesterday's news.
Or, as the investing brochures always phrase it, "Past performance is not a predictor of future returns."
Sound investing decisions should consider context. A look at the trend in prices over the previous 52 weeks at the least is necessary to get a sense of where a stock's price may go next.
Technical and Fundamental Analysis
You can pick investments for your portfolio through a process of technical analysis or fundamental analysis. Let’s look at what these terms mean, how they differ and which one is best for the average investor.
Technical analysts comb through enormous volumes of data in an effort to forecast the direction of stock prices. The data consists primarily of past pricing information and trading volume.
Fundamental analysis fits the needs of most investors and has the benefit of making good sense in the real world.
Technical analysts are not interested in monetary policy or broad economic developments. They believe prices follow a pattern, and if they can decipher the pattern they can capitalize on it with well-timed trades.
In recent decades, technology has enabled more investors to practice this style of investing because the tools and the data are more accessible than ever.
Fundamental analysts consider the intrinsic value of a stock. They look at the prospects of the industry, the quality of the company management, the company's revenues, and its profit margin.
Many of the concepts discussed throughout this piece are common in the fundamental analyst’s world.
Technical analysis is best suited to someone who has the time and comfort level with data to put limitless numbers to use. Otherwise, fundamental analysis will fit the needs of most investors, and it has the benefit of making good sense in the real world.
Aim to keep costs low. Brokerage fees and mutual fund expense ratios pull money from your portfolio.
Those expenses cost you today and in the future. For example, over a period of 20 years, annual fees of 0.50% on a $100,000 investment will reduce the portfolio's value by $10,000. Over the same period, a 1% fee will reduce the same portfolio by $30,000.
Fees create opportunity costs by forcing you to miss the benefits of compounding.
The trend is with you. Many mutual fund companies and online brokers are lowering their fees in order to compete for clients. Take advantage of the trend and shop around for the lowest cost.