Companies issue stock to investors as shares of ownership in their business. Investors can purchase shares of stocks of public companies on stock exchanges. Thousands of companies are traded every day worldwide at the current market price. Investors generally value stocks based on their current and future products, earnings and dividends. There is no way to reliably predict the future market price of a stock, though that doesn't stop people from trying.
Two famous investors, Warren Buffett and Charlie Munger, became successful long-term value stock investors by looking for companies that meet the following criteria:
- Business with a durable competitive advantage (i.e. lasting value)
- Managers must have integrity and talent
- Only buy companies you understand
- Buy at price below intrinsic value
By researching company fundamentals and being patient, Buffett's company has been very successful at "finding needles in the haystack" and outperforming the overall stock market over certain time periods. This process takes a lot of energy, time and patience to achieve success. Unless you are an investment professional, it is generally not worth the time and effort to try and outsmart the market when you can invest in a low-cost total stock market index fund and get the market return. Buffett and Munger are long-term investors, and once they find a company to buy, they hold it forever unless there is a fundamental change in management or competitive advantage.
Our favorite holding period is forever. Warren Buffett
From 1999 to 2002, I dabbled in some individual stocks, including an IPO (Initial Public Offering) and other stocks I thought might do well. I bought these companies because I liked them, not because I had a plan or studied their upcoming plans or management. I made a little money in the beginning, however I held onto the losers until 2002 when I decided to give up on individual stocks and sold them for a loss. My mutual funds were performing so much better with far less effort.
In December 2012 I ran across a company that I felt was a good investment. I had a business meeting at American Airlines a few days after their parent company AMR Corporation had emerged from Chapter 11 bankruptcy and announced a merger with US Airways. After the meeting, it was apparent to me that American Airlines was going places and the stock price for AAMRQ was trading at 59 cents. I had a brokerage account at the time, but it didn't have any money in it. It took a couple of days to move money into it and buy $500 worth for 89 cents a share. Over the next two months the stock continued to climb. In January 2013 I sold some of my shares at $1.50 and got my original $500 investment back and let the rest stay invested. I was unsure what was going to happen to the stock because of the upcoming merger and in February sold the remaining stock when it got to $2.40. I almost doubled my money in two months. I was lucky.
I learned many things about myself from this experience. Once I bought the stock, I had difficulty sleeping. I was already disappointed that I wasn't prepared to buy the stock when it was 59 cents and missed the 50% rise in price to 89 cents waiting for my brokerage account to get funded. I started obsessing about the stock price and monitored it constantly. I had spoken to a mentor about the stock, and they advised me to sell the stock and get my initial investment back and to let the rest of it ride. In the worst-case scenario, I would not lose money even if the stock went to zero. I thought that was sage advice and I slept a little better after selling the first portion. The uncertainty about the merger and what would happen to my stock spooked me and I sold out in February.
What caught me by surprise was how I was unable to sleep and how much I worried about the outcome. By this time, I had a sizable IRA after rolling over 401k's from four different jobs over 20 years. I had only risked $500 on American Airlines and that was many times smaller than my IRA invested in index funds. I guess it was knowing that my entire $500 was at risk if American Airlines would file for bankruptcy again. If I ever buy another individual stock again, I hope I handle it better.
I actually have more experience with individual stocks through my employment. I have worked for several public companies and had opportunities to buy company stock as part of an employee stock purchase plan (ESPP) and in a couple of cases I received restricted stock units (RSUs). The ESPP allowed employees to take payroll deductions for six months to purchase stock at a 15% discount. Once the stock is purchased, I would sell it as soon as I received it to lock in the 15% discount I received. I already had enough financial risk in the company because of my employment, I didn't want to overextend my risk by holding additional company stock too. I had family members that had gotten burned by Enron and didn't want to expose myself to that risk. I was offered RSUs when hired at a few jobs. RSUs are company stock that is granted after a vesting period, usually four years. After the first year I would receive 25% of the RSUs. Since receiving RSUs is a taxable event, I would sell the company stock the same day I received them to lock in the price since I had to pay taxes on that income.
How to make money with stocks
Companies are in business to make money for their owners. For stock investors this is achieved through:
- Capital appreciation
Capital appreciation is when the price of a stock goes up. This occurs when another investor is willing to pay more for your shares than you originally paid for them. Stocks can also decline in price which is capital depreciation. Over time, companies generate a profit or loss. If a company has excess earnings, that company may choose to reinvest those earnings back into the company or pay some of the earnings to investors in the form of dividends. Newer companies tend to reinvest earnings while established companies tend to distribute dividends.
Stocks are priced based on supply and demand in the open market. The fundamental value of a company is based on the earnings that it generates. Some investors evaluate companies based on their price to earnings (P/E) ratio or price to book (P/B) ratio to determine if a stock is undervalued or overvalued relative to the rest of the market.
Price is what you pay. Value is what you get.Warren Buffet
Over long time periods, individual stock prices generally follow a pattern of growth and contraction based on business cycles. However, no company exists forever and the long-term prospect for most companies is to become acquired (merger or buy out) or go bankrupt. For example, here is the monthly history for a $10K investment in General Electric since 1970:
While individual stocks wax and wane over time, stock markets persist over the long haul. A fund is a collection of stocks packaged as a security that can be traded. Two types of funds are mutual funds and exchange traded funds, or ETFs. While a stock represents an individual company, a fund represents a market. Stocks can go to zero, however for a market to go to zero, all stocks in that market must go to zero. In order for a long-term investment in an individual stock to be successful, the investor must select a stock that will survive over their time horizon. While GE has been around for a century, there is no guarantee that it will be around for another century. Stock markets on the other hand have been around since the 16th century. The New York Stock Exchange was founded in 1792.
Publicly traded companies go through business cycles and do not move in lockstep with the market. This means some stocks are overvalued and some are undervalued relative to the market, and over time they will revert to their mean / true value. The price of a stock is determined by how much investors are willing to pay for that stock, regardless of whether that stock is held individually or in a stock fund. Investors tend to look toward the future when deciding how much they are willing to pay for a stock. This means a company can perform poorly one quarter and its price can remain high because investors believe the company will continue to have value in the future. While individual companies tend to ebb and flow over time, the overall market trend is to grow in value as evidenced by over 150 years of market history.
The index fund is a sensible, serviceable method for obtaining the market's rate of return with absolutely no effort and minimal expense. Index funds eliminate the risks of individual stocks, market sectors and manager selection, leaving only stock market risk. John C. Bogle
John Bogle invented the index fund in 1975 as a way to capture the return of the stock market while minimizing risk. The first index fund debuted on August 31, 1976 and simply invested in the 500 largest companies in the stock market. It was later renamed the Vanguard 500 Index fund. When Bogle first introduced indexing at rock-bottom prices, he was called "un-American" by fund managers on Wall Street. Why would any investor want to indiscriminately buy every stock in the market? This would cause investors to buy both good and poor performing companies. Why would any investor be satisfied with receiving just average returns? As it turns out, beating the average return is easy on a daily basis. After all, about half of the stocks on a given day will beat the average and the other half will underperform. If you extend the time frame to a month, year or decade, this is where the magic starts to happen.
Indexing is a proven method for extracting the average return of the stock market. If you simply want to earn the market return, investing in a low-cost total market index fund is the simplest way to achieve this. However, with the stock market it is possible to lose money, even with an index fund, so you need to consider diversifying between stocks and bonds to reduce your risk.
Everything should be made as simple as possible, but not simpler. Albert Einstein
Volatility and Risks
When it comes to money, no one wants to lose it, especially if you worked hard to get it.
Because of risk aversion, investors tend to trade opportunity for safety. Fear is a stronger emotion than greed, and when fear takes over logic, your emotions cause you to make poor choices. There are many fears in investing:
- Fear of the unknown
- Fear of risks
- Fear of missing out
- Fear of loss
Knowledge is the key to dealing with these fears. There are a lot of complicated investment products and believe it or not the simplest ones tend to outperform complex strategies in the long run.
Risk comes from not knowing what you're doing. Warren Buffett
There are a lot of risks in stock investing as Bogle points out. Buying individual stocks involves company risk, which is the risk that an individual company will fail and go bankrupt. You can mitigate this risk by investing in multiple companies as to not put all your eggs in one basket. Buying technology or healthcare stocks involves sector risk, which is the risk that an entire sector like technology or healthcare can have a downturn. The world will always need technology and healthcare, so there is not a risk of these sectors going to zero, however the technology sector was the cause of the dot com bubble in 2000 which caused the NASDAQ to decline 78%.
Some investors dislike volatility when they see the value of their portfolio decline. To put volatility into perspective you need to zoom out and look at the bigger picture / longer time frames. Below are three charts displaying the past two months, two years and 20 years of the S&P 500 respectively.
Note the longer the time frame the smoother the volatility and the general uptrend. Past performance is no guarantee of future returns.
Buying an active mutual fund that attempts to pick winning stocks to outperform the market involves manager risk. These managed mutual funds can charge 1-2+% for their services. In order to beat the market index managers must outperform the index by at least the management fees they charge for you to come out ahead. Beating the market return becomes increasingly difficult over longer time periods.
There are eleven different sectors that are tracked in the U.S. stock market. Each of these sectors represent a major investment category. Some believe that sector investing is cyclical in nature and by rotating your portfolio into different sectors you can beat the market return. Each year the annual (one year rolling return) for each sector varies greatly and is totally unpredictable. Below are recent sector returns:
However, if you look at the 15-year rolling return for each sector in the stock market, you will start to notice longer term performance trends for each sector. (i.e. sector performance relative to each other starts to form a pattern and look less random) You may also observe that multi-year S&P 500 performance starts to outperform individual sectors. In addition, the longer the return period, the less likely you will see a negative performance return. Past performance is no guarantee of future returns.
The stock market has been analyzed a million different ways and there are just as many strategies as there are people who invest in stocks. A lot of research has gone into modern portfolio theory, and there are very few strategies that stand the test of time. Indexing is one of them. Many strategies work for a particular time frame which you can backtest, however they don't work for all time frames. Or you may find a strategy that stops working after a certain year because of competition.
The stock market is very competitive, and many smart professional investors compete against each another and have come up with many complex strategies to beat the market. You can sell short to make money when stocks go down, use call / put stock options, futures, margin trading, leveraged funds, arbitrage, day trading, etc.
Two heads are better than one, and while you may be smarter than some investors, we are not smarter than the collective consensus of all investors that make up the market. This is why markets are so difficult to predict.