During financial booms, any topics related to investing money get a lot of attention. Sadly, scams and speculations get a lot of attention as well, and people start trying out different ways to ‘get-rich-fast’.
They try to recruit their friends to really sketchy schemes, which usually result in financial losses. But it often ends even worse, as schemes like these can also be the root cause for entire friendships to end.
This leads a lot of us to ask ourselves a simple question: why should I voluntarily do anything with my money other than keep it in my bank account?
We’ve heard countless stories of people losing all the money they ‘invested’ during the last financial crisis in 2008/9; how their friends’ promising idea ended in disaster; the promise of 100% yield didn’t come true; and how they lost money, friends, and in some cases even their homes.
To illustrate this, an acquaintance of mine told me he lost over 300K in the last financial crisis and never wants to invest again. I understand his feelings, but I also think there are several things that could have been done to avoid this scenario – such as focusing on timing and the value of the investment. I’ll delve into them shortly.
This article is meant to explain the most basic concepts about value investing, which are not taught in schools, sadly. Everyone should be aware of this basic stuff before making any investment decisions.
I’m not a financial advisor, nor do I have a degree in finance, or even 10-20 years of experience (well, I’m 26) in the field. Therefore, take my opinions with a grain of salt. I’m purely writing about things I’ve read and experienced, which I feel are useful and worth sharing.
Why are We Afraid of Investing?
A lot of the fear that comes with the word “investing” is down to people misusing the word. A lot. If you decide to put your money into a Ponzi scheme or other sketchy opportunities, it’s not called investing. It’s called speculating or gambling, as also mentioned in my previous post.
If you buy a stock today and sell it tomorrow, this is called trading (which is a form of speculation, where you basically bid that the stock price is going up and hope to win some money by selling it more expensively than when you bought it).
Due to the lack of financial education in our school systems, we tend to think that gambling is the same as investing. When in reality, it’s not.
Another reason we’re afraid of the word ‘investing’ is that it sounds unreachable, or something unattainable to ‘regular’ people. As it’s not taught in schools, we need to figure it out on our own (or we need to have parents/friends who are knowledgeable in the field).
Part of the reason I started this blog, is to make sure that my friends would learn stuff that they haven’t been taught but is so necessary to know in the real world.
I believe that lack of knowledge on financial topics is widespread, and that’s what gives sketchy schemes and scams the chance to thrive. People just don’t know the difference. They think it’s all the same and categorize the scams as “investing”. They get burnt once, and never want to deal with any type of money allocation again.
Losses inflicted by these schemes lead to opinions like ‘the entire stock market is one big speculation’ or even ‘the whole world of finance is a huge speculation’.
There’s definitely a lot of manipulation built into the world finance and stock markets, but to call the entire world financial market a hoax is also an exaggeration.
This Terrifying Word…
I also used to be afraid of the term ‘investing’ before I started educating myself on financial topics. I had a pretty big barrier to overcome just to read any finance books, as I hated maths at school and I’ve never been good at it (with the exception of 3rd grade, if that counts).
The only experience I had earlier was looking at the news and seeing the hassle on Wall Street. Back then, I knew nothing about Wall Street, stocks, bonds, dividends, and other what-seemed-so complicated terms.
It all seemed distant and irrelevant to my daily life, so I just skipped that part of the news.
The funny thing is that now, I’ve pretty much reached the same stage again, as I really don’t care whether the stock I bought moved up 5% or down 15%, as it doesn’t matter when you practice value investing. I’ll go into details shortly.
How to Differentiate between Speculation and Investing?
It’s simpler than you think. Investing is the action of buying a financial asset, or security, such as stock (buying a small part of a company) or bond (in essence, a loan that is given from an investor to a borrower), in hopes of receiving more money later. The potential of receiving more money later is the reason why people invest in the first place.
The main ways you can generate extra money from investments:
- Selling the asset – for example, you bought a share of a company for 100 € and sold it for 150 €.
- From dividend payments – company distributes some of their profits to their investors/stockholders. It’s also called ‘passive income‘.
- From interest payments – you’ve loaned money and the borrower pays a certain amount of interest on that, just as you pay interest on your credit card, mortgage payment etc.
- From rent payments – when you’ve bought property and receive monthly rent payments from it.
The cool thing with any long-term investment (and by long term I mean 10+ years) is that you don’t need to worry about whether the price of your investment moved up or down.
All you need to worry about is the quality of your investment – and this worry should be experienced before making the investment decision.
Get your Facts Straight
For example, if I want to buy an apartment to rent out with the aim of earning money, before buying, I make sure that the location of the apartment is good, it won’t collapse in the next 20-30 years, I can easily find a tenant to live there, etc.
“Would you start selling your house if its value dropped by 10%? If not, then why do you sell a stock if it drops 10%?”Howard Marks
With investing in stocks/buying shares of companies, it’s even easier than real estate. With real estate, there can be hidden issues with a property, which you may not have been told about, and can prove expensive to fix later on.
To analyze a stock, you simply Google the financial data of the company you’re interested in and analyze it carefully.
You want to look for similar things as when buying an apartment: can I earn constant revenue from it? Is it a high-quality company, or is something sketchy going on there (for example, could it collapse in the next 20 years?)
Besides asking these questions, you also need to look at the company’s financial data – such as EBITDA, ROI, cash flows and other data, which I’m not going to delve into right now. When you have the financial data, you can calculate what’s the intrinsic (or actual) value of the company.
From the balance sheets and other financial documents, you can see how the company has performed in the past – has it had years where they weren’t profitable? If yes, then why? Have they paid increasing dividends to their investors? What percentage of their profits are they paying to investors? Is there room for growth?
However, you shouldn’t make your investment decisions based only on the past. You should try to look ahead and analyze whether the company has the potential to grow, whether the area they’re operating in has the potential to grow?
For example, the most well-known company in the investment world, Berkshire Hathaway (led by Warren Buffet), recommends investing in companies which are basically bulletproof. He says:
“Invest in a business any fool can run, because someday a fool will.”Warren Buffett
If you apply this rule to your investment strategy, it may not make your investments completely bulletproof, but it’ll give you confidence that even during recessions, the companies you’ve invested in won’t be losing 90% of their value or going bankrupt.
What to Look for in a Company When Investing?
There are so many things you can look into about a publicly traded company, which should give you a pretty good overview of their past, present, and future.
Which things you should look at exactly will be a separate post, although I’d like to elaborate a bit on the concept of “intrinsic value”, as it’s one of the main things which shouldn’t be overlooked when investing in the stock market.
From the graph below, you can see that the company’s intrinsic value can sometimes be underpriced, overpriced, or close to its actual (or intrinsic) price.
Smart investors buy stocks with a discount, meaning the market price is below the company’s intrinsic/actual value. This results in higher earnings for your money, as you get to buy more shares of the company when the price is lower, and therefore you have the chance to receive more dividends, as you hold more shares. Dividends are paid per share.
However, as many people don’t know how investing works, they buy high and sell low, and therefore can lose a lot of money, like the example above of my acquaintance losing 300K during the recession.
During this period, some stocks lost as much as 90% of their value. This could have been avoided if people had calculated the intrinsic value of their stocks, or at least looked at some basic financial data of the companies before buying them.
Speculation has demonstrated its often inevitable disastrous consequences several times throughout history. For example, even as far back as in the 1630s, there was a Tulip Mania boom in Holland, which saw the cost of tulips skyrocket, as bulbs for fashionable and trendy tulips reached absurdly high prices.
At the peak of the mania, some tulip bulbs were sold for more than 10 times the yearly income of a skilled craftsworker (for reference: 1 bitcoin cost €17K at its peak in 2017, which is close to the Estonian average yearly salary – and this bears similarity to the tulip mania, even though it’s almost 400 years later).
By the end of the mania, some tulip bulbs changed owners ten times a day. Many people made and lost huge amounts of money overnight. As the farmers sold their as-yet unproven bulbs at extraordinary prices, it pushed the market into the frenzy and the mania collapsed in 1637.
As the market is cyclical, such speculative investment elements have always been out there, just in different shapes.
How to Identify Speculation?
When speculating, you’ll rarely find income streams similar to those from investing, and they’re often based on empty promises, not real numbers.
For example, when you’re trading on the stock market (constantly buying and selling stocks in hope to gain profits) you’re forecasting that a company’s stock goes up. You have no financial data to prove that the stock price goes up. It can just as well go down.
Basically, you’re making a decision out of the blue, and hoping your gut feeling doesn’t let you down. The statistics say that in most cases (95%), it lets you down.
Besides trading, there are even more speculative elements out there, just to name a few: options, junk bonds, cryptocurrencies, and pyramid schemes. What’s similar in all of them is that it’s basically impossible to tell their real (intrinsic) value.
There is no tangible value behind it to evaluate how much should the element be worth, and people use them to get rich fast (which is basically mission impossible).
When speculating, you can’t ask simple questions as you can with long-term stock investing, such as ‘what’s the profit this element generated last year?’ or ‘What’s the cash flow the pyramid scheme/Bitcoin generated last year?’
You can, of course, ask these questions, but there’s no way you can validate the answer (even if you get one). You can’t see the financial data – such as EBITDA, ROI etc., which are all crucial when making a value investment decision.
What Would I Invest in and Where Have I Invested?
As I don’t want to gamble with my money, I avoid everything that has ‘speculation’ written on it, and so should you. There are theories out there which say that you can allocate about 2% of your portfolio for speculation.
Maybe one day, when I have more funds available, I’ll buy some speculative stocks or something similar, but I’m not currently in the place to act irresponsibly with my money and take high risks.
I’ve invested into crowdfunding platforms (which I won’t discuss in detail in this blog post) but I’ve now fully exited from them due to my conservative and defensive investment strategy.
Crowdfunding platforms usually produce higher earnings, but as mentioned earlier – higher earnings mean higher risk.
My current investments are mostly in long-term U.S. dividend stocks. As the name says, they’re long-term (10+ years), meaning I probably won’t be selling them anytime soon.
Long-term dividend stocks produce constant cash flow for investors, which you can then re-invest to buy more shares or use as you find fit. I prefer the first option, as then I can earn more passive income in the future.
I only buy shares of companies which have proved themselves over a long period of time (my main condition is that at least one financial crisis needs to be in their history. For example, crowdfunding platforms don’t qualify, as they started emerging after the last financial crisis).
Companies which I trust are called Dividend Kings and Dividends Aristocrats. They have paid their investors rising dividends for 50 and 25 years respectively. These are all companies which are known worldwide – such as McDonald’s, Coca-Cola, Chevron, 3M etc.
As they’ve paid rising dividends for that long time, they’ve seen several financial crises, but continued to pay increasing dividends to investors even when everyone else was sure the world’s going to collapse.
In the next couple of years, I’d also like to add real estate investment(s) to my portfolio. I’m a complete real estate freak and would (probably) enjoy managing properties.
Here are some major questions I always want to ask before I buy any stocks (not a complete list):
- What’s the reason leading me to buy this stock? Is it a friend’s recommendation, or is the decision based on my financial analysis of the company?
- Is it worth the price?
- What’s the world economy’s current state? What part of the cycle are we in?
- What’s the company’s financial history? How has it performed in the past?
- Does the field in which the company operates have a monopoly?
- Does the field in which the company operates have potential for growth?
- What are the potential risks this company might have?
It’s worth bearing in mind that lower risk also means lower returns. But I believe it’s better to have lower returns (5-10%) than to lose your money.
- Should You Invest in Real Estate or the Stock Market
- Book Review: The Dividend Mantra Way by Jason Fieber.
- Why it Matters to Adopt Good Financial Habits
Is Gold an Investment?
Investing in precious metals, such as gold, has always been a hot topic and I do believe that gold is a justified investment in extreme cases (war, hyper-inflation etc.).
However, gold is not an investment where you can hope to receive high yields during ‘normal’ times when the economy is strong.
But when the economy weakens, demand for stocks and other financial assets declines, and people tend to turn towards more tangible and ‘stable’ assets, such as gold (and also cash). This also means that the price of stocks and other financial assets goes down and in most cases unjustifiably.
The percentage of precious metals in your portfolio can be dependent on how skeptical or optimistic you are about world leaders getting on well and not causing a major war. And also your geographical location.
I’d probably have a lot more precious metals in my portfolio living in the Middle East vs living on a small island somewhere in the middle of the ocean.
Timing your Investments
These are the 2 most important factors to look at when investing (in stock markets).
- The timing of the investment
- The quality of the investment
These factors need to be analyzed separately, at all times. At first, I recommend you find out whether the company you’re investing in is worth investing in at all.
And then, you should look at the price at which it trades – see if it’s overpriced, discounted or at its fair value.
You might find a high-quality company you’d like to invest in, but it can be completely overpriced, and therefore a bad investment, as it won’t result in any financial gains. If you buy stocks in a bull market, you’ll most likely overpay for them.
Or as Graham puts it:
A stock can be an investment if the intrinsic value of the company is sound and the price paid is low or reasonable compared to its value.Benjamin Graham
No offense to taxi drivers, but there’s a good saying: if your taxi driver is talking to you about investing, then you know the market has reached its peak (or bull market stage) and you should adopt a conservative investing strategy. This means selling some of your highly overpriced stocks and keep some extra cash with you.
When it’s the bear market (or the market is at its lowest point), it’s a good idea to put your savings and earnings into work and buy stocks, as they’re most likely heavily discounted. It’s like shopping in a store where “everything’s up to 70% off” – it should be tempting not to buy.
Besides the questions I mentioned above, there are some other questions you should ask yourself before you start with investing:
- What do I want to achieve with investing? Do I want to get rich fast (high-risk! and 95% chance it won’t happen) or do I want to adopt a safer way to financial freedom? Do I even want financial freedom?
- What stage is the world economy in? Are people around me enthusiastic about investing? Or are they afraid the world will end, or somewhere in between?
- What do I know about investing? How much have I educated myself about the topic?
- Should I educate myself further to make a well-calculated decision?
If the economy is distressed, then it’s the best time to buy. Because even if the world ends, then nothing’s going to matter anyway. But if it doesn’t end, there’s much to win as you got to buy assets at discounted prices which produce you constant cash flows.
I believe the blog you’ve just read should be taught in schools and is a knowledge that so many people are missing. There’s a lot more I want to say, but I won’t, as then I’d be writing a book.
Ultimately, investing and speculating can be differentiated largely by the level of risk involved. With value investing, the risks of losing money are much lower than with speculation, as you can clearly see the real value of the company, and analyze whether it’s overpriced, discounted or true to its current value.
And here’s a really good podcast that I just listened about value investing:
The Tim Ferriss Show – Howard Marks and ‘How to Invest with Clear Thinking’.
- Should You Invest in Real Estate or the Stock Market
- Book Review: The Dividend Mantra Way by Jason Fieber.
- Why it Matters to Adopt Good Financial Habits