Many people across the world wait eagerly for Warren Buffett’s Annual Letter to the shareholders of Berkshire Hathaway Inc. Some are looking for suggestions for stocks, while others are looking for investing lessons worth learning. Everyone, though, is keen to know how much money the ‘Oracle of Omaha’ has made this year!
This year was no different, and on 24th Feb. 2018, Mr. Buffett wrote that Berkshire Hathaway made $44.94 billion – BILLION – in 2017. It is times like these, that many of us enviously think of investing in stocks ourselves. If I find a few stocks that will double of triple in value this year, I can make a lot of money! Right? Read on to understand why this is a really bad idea!
Daniel Kahneman’s book Thinking, Fast and Slow explains the ‘Law of Small Numbers’ as the tendency of people to look at results in a very small group and expect the same in a larger group. For example, “My uncle made a lot of money by buying a stock many years ago so maybe I should buy some shares too.” or “My friend bought a house 3 years ago and it’s price has doubled! I should try to get into the housing market too!”.
We don’t seem to see the flaw in this logic. It is like saying, “That guy jumped off the 10th floor of the building and did not die. So it is safe for me to do so too!”.
As I have already mentioned in my post about Bitcoin, it is not advisable to invest your hard-earned money in something that you do not understand. So you should only invest in businesses/stocks that you understand and know. This might seem like a very simple and straightforward sentence, but let’s break it down and see how complex this really is.
Step 1. Choosing a sector to invest in
In my Nutmeg Stocks and Shares ISA, I can see my money invested in about 15 different sectors such as financial companies, technology, heavy industries, healthcare, energy, consumer goods, telecommunications, real estate and so on. To choose which stocks to buy, you will first need to understand which sector to invest in. It could take months to do your research and learn how a sector works, what are the various factors that impact it’s profitability, what are the laws and country-specific regulations, what are the risks that the sector faces etc.
Analysing a range of sectors before choosing one requires a lot of effort. It is difficult to know all the different activities happening globally that might impact your investment within a sector. For example the ‘Financials’ sector in the U.S. was the biggest loser in February’s stock market crash even though the trigger for the crash – rising interest rates – is usually expected to help banks increase their profits.
Further, even if you learn about a few sectors, you need to understand some level of financial and economic jargon to compare them and predict which sector will be a better investment. Despite all this, choosing one over the other involves speculation and once you are invested, it is difficult to move your money around.
Step 2. Calculating the ‘true’ value of stocks in the sector
Market price of a company’s shares is not the same as it’s intrinsic or ‘true’ value. Valuing businesses is almost an art. You can only learn this art by reading lots of financial statements, annual reports and research papers. Then you will need to know how to run financial calculations on your own to estimate the ‘true’ value.
Owning shares of a company also give you many intangible benefits such as voting rights. These cannot be valued. Further, many companies do not pay dividends while some do. How do you compare these two types of companies?
There are many ways people value stocks. Some use complex mathematical models, while others use past performance to predict future growth. Whichever way you use, there are just too many variables that can affect a stock’s price. It is almost impossible to track all of them.
Step 3. Finding companies available below their true value
Philip Fisher, a well-known American stock investor best known as the author of Common Stocks and Uncommon Profits, introduced a simple principle of investing – “buy businesses that are undervalued”.
This reminds me of Yogi Berra’s excellent quote “In theory there is no difference between theory and practice. In practice there is.”
When everyone is trying to do the same, it can be very difficult to find businesses that are undervalued. You may spend months looking for such opportunities while your money waits in your bank account. When you do find such a stock, it may be too late and your money may have already been invested elsewhere.
Major financial trading companies and professionals spend a lot of time and effort trying to find stocks that are undervalued. As an individual investor competing with them, I don’t fancy my chances of finding a better deal very often.
If you do come across an undervalued business, you should ask yourself a few questions. Why would this business be undervalued? Won’t an undervalued business immediately be bought by investors, thus driving it’s price up and making it overvalued or ‘rightly-valued’? To buy a stock that is undervalued, there must be someone that is selling too. Why is that person selling? It is very likely that I do not have all the information available at the time of buying. So there is a great risk that I commit myself to a stock that is actually going down in value.
Step 4. Deciding when is the right time to sell
Let’s say you managed to do all this (or just got lucky) and bought a stock at a good price and now the price has doubled. Do you sell? What if it increases many times more? When do you actually sell? The obvious answer is that you sell when the price surpasses your calculated true valuation for the stock.
The real world works in many different ways though. What if the stock price starts falling when you expect it to go higher? Should you sell and avoid a loss? Or should you wait for it to bounce back? What if there’s something going on at the company that you aren’t aware of which is causing the share price to fall?
In another scenario, let’s say the stock price goes up a lot but doesn’t yet match your calculated true value. Should you book your profits and sell? How much longer would you wait?
As you can imagine, knowing when to sell is the most important decision in any stock transaction. And even after you buy a stock you need to continuously monitor the progress of the company and sector so that you are not relying on luck to make your profits.
Assuming all of this works out, you may still not make much money overall!
Most individual investors won’t put more than 5% (or a similar small amount) of their wealth in a single stock in order to reduce the risk of losses. Let’s say you have a massive portfolio of £100,000 invested in stocks. That means £5000 is invested in 20 stocks. If two of your best performing stocks double in value in one year (which is very rare) and none of your other stocks lose anything (which is also very rare), you have just made £10,000 profit. That is 10% return in a year. Not bad but not spectacular for all the effort you’ve put in steps 1-4.
Then you have transaction costs, taxes and other fees to pay. This reduces your profits even further. So when you actually measure your profits over the long-term, you will realise that the benchmark index itself (S&P500, Dow Jones, FTSE 100, Sensex etc.) usually perform better than you. This is true even for professional fund managers, let alone individual investors like you and me. “Index funds will do better long-term than professionals, because the professionals, after fees, don’t know how to get a better results” said Warren Buffett himself!
So if you want to invest in the stock market, it may be easier and better to simply invest in an index-tracker fund and spend your time and effort doing something else!
This is just a very simplified opinion about why individuals trying to pick stocks for investing is not a very good idea. We haven’t even discussed the speed of information travelling (by the time you hear the bad news, the stock price has already fallen), high-frequency trading technology (very fast computer algorithms designed take advantage of micro-changes in the stock prices), the limited protection shareholders have against fraud, insider trading, company bankruptcy and so on.
Inspite of all these reasons, if you still want to try picking stocks to invest in, all I can say is – best of ‘luck’! That’s probably the only thing that will help you!
The article was originally published on The Millennial Investor