The Principles of Investing

While the principles of investing are actually not that complicated, few individual investors have a solid understanding of them. This is largely because investing is not taught as a basic academic subject, which is unfortunate because it leads to poor financial decisions by a large number of people. In this brief overview we will cover a few basic topics that we believe are critical to financial literacy.

Investing is a broad term, but in essence it simply refers to the exchange of money for an asset that is expected to provide a return greater than cash in a savings account. If one cannot expect to earn a return greater than cash, there is no point of investing. In finance, the rate earned by cash in a savings account is referred to as the risk free rate. As the name implies, this is the rate earned without taking on any significant risk. However, in order to achieve a return greater than the level of inflation, one must take on risk. Intelligent investing is largely the science of managing risk. As with anything, one can take foolish risk or well-reasoned risk.

To keep things simple, this discussion will focus on two asset classes – stocks (equities) and bonds (fixed income). When someone says that they own stocks, typically this means that they own individual stocks that either they or someone else selected. This type of investing is referred to as stock picking. For example, a stock portfolio may contain shares of Apple, Amazon, and Tesla. In order to determine if the stocks selected are performing well, one needs a basis of comparison. In finance, stock portfolios are compared to the performance of the market average, which is also referred to as an index.

In order to be an astute investor, understanding the concept of indexes in the context of investing is critical. An index is simply a large group of stocks. Some examples of popular indexes are the Dow Jones Industrial Average and the Standard and Poor’s 500 Index (S&P 500). The S&P 500 Index consists of the largest 500 companies in the United States and effectively represents the average performance of these 500 stocks. So why would one want to compare their stock portfolio to an index?

The reason it makes sense to compare a stock portfolio to an index is that there are several ways to own the index at very little cost. The most cost efficient manner is through an Exchange Traded Fund (ETF). ETFs have significantly lower fees than mutual funds and can be bought and sold like a single stock. So if one’s own stock portfolio cannot beat the S&P 500 Index over a multi-year period, they would be better off by owning an ETF that mimics the index.

Many people focus only on returns, but risk is an essential component to understanding investing on a basic scale. Someone that holds a portfolio of 10 stocks is taking on significant risk by concentrating their holdings. If one of those 10 companies goes bankrupt, that person just lost 10% of their wealth. With an index, the risk is spread over hundreds of stocks so in the event a company goes bankrupt, it does not cause significant losses.

Another very important concept related to investment risk is risk adjusted return. Risk adjusted return, also known as the Sharpe Ratio, refers to how much return a portfolio generates for every unit of risk it assumes. It is effectively a ratio that divides return by risk. For example if one portfolio yields a 20% return with a 10% level of risk, it is said to have a risk adjusted return of 2 (20%/10%). If another portfolio yields a 30% return with a 30% level of risk, it is said to have a risk adjusted return of 1 (30%/30%). Someone may be instantly attracted to the investment that returns 30% because it is greater, but in fact the investment that yields 20% is far better due to its greater risk adjusted return.

Emotional investing is one of the principal killers of investment returns and an important concept to consider. In fact, there is an entire field dedicated to behavioral finance, which seeks to determine why people make irrational financial decisions. For individuals, an example of this would be holding Amazon stock because they have an affinity for the company or its services. This is not a good reason to own a stock, especially if one is oblivious to the financial standing of the company. Additionally, emotion can cause people to get in and out of markets at very bad times. The mantra of “buy low sell high” usually becomes “sell low buy high” for emotional investors. What many people do not realize is that the best investing should not be exciting at all.

Whatever a financial expert may tell you, predicting market corrections is impossible. Many will claim that they can time the market using technical analysis, but this has never been done accurately and on a consistent basis. At VL Capital Management, our research has shown that large-scale economic events, such as recessions can be predicted.

If someone buys a few stocks, they are said to be actively betting that they can outperform, or beat, the passive index. Buying Apple stock, for example, is equivalent to betting that Apple will outperform the market index. With passive investing, one simply buys the index using an ETF because they do not believe that they can outperform the market index. In reality, the majority of individual stocks fail to beat the market average over long periods of time.

With passive investing, one has accepted the fact that they cannot beat the index and will accept market returns for their portfolio. For most individual investors, this is the most intelligent strategy to undertake. Even famous investors, such as Warren Buffett, recommend passive investing because one of the most difficult things to do is beat the index. Passive investing both mitigates risk and ensures performance in line with the broader market.

There are also managers that do not try to beat the index, but rather try to diversify investors’ money across multiple asset classes, such as stocks and bonds. This makes logical sense because concentrating wealth in any one asset class increases risk. When stocks do poorly, bonds might do well, and since the portfolio is exposed to both, there is less volatility. Passive managers typically charge significantly lower fees than active managers because they are simply buying ETFs.

Active investment managers, seek to beat the index, which is a very difficult feat. The vast majority of active managers fail miserably in this pursuit, therefore there is little hope for any individual investors to beat the index themselves.