While prudence will drive the beginner investor to follow market trends and stay conventional, time, experience, and the desire to earn higher returns should soon compel them to become an intelligent investor. It’s unrealistic and foolish to try to beat the market, but raising your investing intelligence could bring you a rate of return on your portfolio of 10% to 12%.
Becoming an intelligent investor requires you to realize that while the Efficient Market Hypothesis (EMH) is frequently correct, it is by no means infallible. The EMH attests that market prices are always at their correct value. Information available to investors will be available to everyone else, so it’s already included in the price. While the theory is illuminating, the intelligent investor recognizes that it’s not always true. There’s a lot of noise in today’s markets, and in the short-term they’re often driven by trends, gossip, and even magical thinking rather than core value. The market will usually reverse to the mean (known as long-term mean reversion, which leads prices back towards their fundamental values), so becoming an intelligent investor requires you to think long-term – over at least 25 years.
Unfortunately, most financial advisors will be rewarded by their performance over a few months, so they’re not always motivated to abide by intelligent investing principles. They also usually charge exorbitant fees. It might be preferable to tackle your own portfolio once you have the knowledge and confidence to do so.
The fundamental question to ask is, “Why am I buying what the person in front of me is willing to sell?” One of you will be making a mistake, and your job is to make sure that you’re not the mistaken party. Now, mistakes often happen in the market. Maybe the other person is panicked that prices are going down, and forgets the market axiom to buy low, sell high. Or you might be tempted by the fact that so many other people are willing to buy, even though you don’t see the core value of the company.
You should have already done an audit of your current financial situation. What are your assets and liabilities? Other than a mortgage, make sure to repay all your debts before investing, especially your credit card debt, as credit cards usually carry an interest rate that is well above 10%, which is the return you should aim for.
Here are some more tips on how to invest intelligently:
- Try to buy low and sell high – and rarely. We may feel the urge to buy more when a stock’s value is rising, but this might indicate that it’s already peaked, and the bubble is about to burst. Alternately, when a stock is dropping, we’ll likely want to sell, when this is actually a great time to buy. As long as the company has solid value, the market will readjust.
- Don’t chase hot tips, whether it’s penny stocks or a tip from your brother-in-law. Do your own research. Some people claim to see patterns in the stock market, which is impossible.
- Avoid bandwagons and jumping on what’s being promoted in the media. Remember that for fashionable stocks, the fashion is already in the price, and once that fades, so will your money.
- Diversify your portfolio. Invest less in banks, pharmaceuticals and oil companies, and more in activities like gold mining and timber. Maintain that diversity globally as well; look to Japan, Russia, or Taiwan.
- Look for fundamental value. The company should be transparent and clear in its presentation, the executives experienced and business-oriented (as opposed to self-aggrandizing), and the business model clear and sound. Focus on stable businesses like water. The aim is to invest in good companies that are out of fashion.
- Think long-term. Over the short term, the market mostly tallies people’s opinions on the popularity of companies. Over the long term, it works more like a weighing machine, measuring companies’ fundamental value.
- Watch for snakes. If the company’s practices, values, or executives make you squirm, then don’t buy. A snake will always be a snake.
- Anchor in the right place. Anchoring means mentally clinging to a reference point, usually the price you paid for the stock. This value is worthless. The point you should be anchoring to is the value of the company, which is the cash flow it will generate over its lifespan.
With these tips and insights in mind, you’re on your way to becoming an intelligent investor. Good luck!
The Edge Team