At the extremes, both bull markets and bear markets cause investors to replace logic with emotion.
Bull markets can create investor manias and a fear of missing out, or FOMO in today’s pop lingo. Bear markets trigger fear and cause investors to place an unreasonably high probability on the worst possible outcome. Both phenomena produce poor results as investors discard logic and act purely on emotions.
In this post we’ll discuss four investment concepts to help maximize logic and minimize emotion which should lead to better outcomes. They are:
- Develop an investment discipline and stick with it
- Use Dollar Cost Averaging
- Diversify Your Assets
- Seek Income before Growth
Is there is such a thing as dumb luck? It probably happens occasionally. More often though it is preparation that leads to something that looks like luck. The preparation I’m talking about here is an investment discipline.
An investment discipline is simply a repeatable process or a formula that an investor uses to identify stocks and/or bonds.
More specifically the discipline should be developed to identify investment candidates that are suitable for the investor’s particular risk tolerance and goals.
Famous Berkshire Hathaway CEO Warren Buffet has a discipline. Mr. Buffet buys what he believes are good quality businesses trading at a fair value. He likes firms that have strong brands, good cash flows and a history of returning capital to shareholders.
Mr. Buffet generally follows his discipline, then buys and holds. For example, Berkshire Hathaway has held Coca-Cola company since 1988. Buffet generally only sells if he later determines he made a mistake in the identification of the investment (Mr. Buffet talks about his IBM investment here).
Dollar Cost Averaging
Dollar-cost-averaging is partially about making investments on a recurring schedule and partially about a math formula. To understand the concept, it’s important to understand the math first.
Let’s pretend you have a child named Erin. Erin loves baseball and is an avid baseball card collector. Erin is also an entrepreneur and will be earning $10 a week walking the neighbor’s dog for the next three weeks.
Each Saturday for the next three weeks, you take Erin to the candy store to buy $10 worth of baseball cards. For some reason, the price of baseball card packs changes regularly.
Here’s what happened. On week #1, one pack of cards cost $5.00, and Erin bought 2 packs. On week #2, prices plummeted 50% to $2.50, so Erin smiled and bought 4 packs. On week #3 prices collapsed another 20% to $2.00 and Erin bought 5 packs. At the end of the third week Erin had invested $30 and purchased 11 packs of baseball cards.
The prices Erin paid for the card packs averaged $3.17 per pack (($5.00 + $2.50 + $2.00) divided by 3). Because Erin invested regularly, Erin bought less cards when the price was high and more cards when the price was low and therefore averaged only $2.73 per pack ($30 divided by 11). This is dollar cost averaging.
Diversification is a way to manage risk. It is also a bit of a double-edged sword. Some of the richest people in the world today created their wealth by not diversifying and owning only one stock. Elon Musk owns Tesla stock. Jeff Bezos owns Amazon stock. Bill Gates owns Microsoft stock.
That sounds easy, however, both the risk and the volatility of owning a single investment can be extreme. Does anyone remember Eastman Kodak Company, Enron, Woolworth’s, or Pets.com? These are all companies that at one time were leaders in their field and had significant stock value. Now they are worthless.
Owning fledgling start-up Microsoft in the 1980’s when the world ran on mainframe computers and IBM dominated technology would have been extremely difficult to do. Apple computer (now just Apple) after going public in 1980 went from riches to rags back to riches. Holding it throughout that entire period would have been practically impossible.
To reduce the volatility and risk of owning a single investment, most investors diversify their holdings. Even Warren Buffet is diversified. His Berkshire Hathaway holding company owns 26 publicly traded stocks. His firm has even owned a few bonds over the years.
All investments have risks. Stock investments have market risk, company risk, and other risks. By owning a basket of around 35 or more stocks from different sectors, an investor can essentially diversify away company risk leaving primarily market risk.
Diversification can go further than just creating a portfolio comprised of several different stocks. Professor Harry Markowitz developed the mathematical theories which became known as Modern Portfolio Theory, and in it, the concept of the Efficient Frontier.
Professor Markowitz’s studies showed that investors can optimize a stock portfolio based on a given level of risk. How? By adding other types of investments, like cash, bonds, and alternatives, to a portfolio of stocks.
In his theory, investors should be able to find diversified portfolio compositions that provide the same or better returns with lower risk than a less diversified stock-only portfolio.
With interest rates at or near all-time lows, why would an investor want to seek income? Virtually all investments are valued based on their ability to create a future stream of income or cash flows.
To better understand why income is so important, consider the simple example of a corner grocery store. Let’s say you decide to open a specialty grocery store near your neighborhood. You have an analytical mind, so you develop a set of assumptions on a spreadsheet.
You determine what your upfront costs will be, and how much it will cost to operate the store. Next, you determine how much revenue your store needs to generate to cover your costs and survive.
You also want to make a profit. You forecast how your revenue will grow over time eventually surpassing your costs creating a profit. Then you start plotting your profits (your income or cash flows) out into the future.
Will your store have value if you want to sell it? Yes, but usually only if it is profitable. Besides, you don’t want to sell it now. You are more interested in the cash flows you can collect over a period of years.
Does that mean you should avoid buying companies that pay no dividend? Not necessarily. You are interested in their internal cash flows, and their ability to re-invest cash flows and continue to grow the business. This is another Warren Buffet specialty; his Berkshire Hathaway company pays no dividends. All its profits are reinvested.
Now back to your corner grocery store. As your profits grow, you reinvest your cash flows into a second store, a third store, a fourth and so on. With each new store, your cash flows grow as does the intrinsic value of your business. So, at its essence, it is the income/cash flow that facilitates wealth creation over time.
This material is provided by Schmitt Wealth Advisers for informational purposes only. Schmitt Wealth Advisers does not provide tax or legal advice, and nothing herein should be construed as such. It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Opinions expressed by Schmitt Wealth Advisers are based on economic or market conditions at the time this material was written. Economies and markets fluctuate. Actual economic or market events may turn out differently than anticipated. Facts presented have been obtained from publicly available sources (unless otherwise noted) and are believed to be reliable. Schmitt Wealth Advisers, however, cannot guarantee the accuracy or completeness of such information. Past performance may not be indicative of future results.