Investment 102: Stocks

It is customary when giving investment advice to provide a disclaimer about your qualifications, self-interest, or bias. Unfortunately, these disclaimers are attached at the bottom of complex documents and written in fine-print legalese, so that mere mortals don’t actually read them. My disclaimer however is rather simple:

Although I am a financial pro, I am not a stock expert. If you think by reading the next few pages that you will become expert in stock investing, please ask me to refund all of your money right now!

I have never charged anyone for investment advice, so please don’t send me any of your gains on investments, nor a bill for any of your losses. Having given that warning, I will now plunge in:

Investing in stocks can be quite good if you are cautious, disciplined, skeptical, and:

If you are not expecting to make a quick, dramatic gain. This is a long-term business where only enduring investors do well.

If you understand that every stock and every industry has significant cyclical swings, up and down. That is the basis of stock market psychology: the bears are always seeing the dark side, while the bulls are eternal optimists; each of these groups is right about half of the time. Don’t become a bear or a bull. Stay dispassionate.

If you distrust the experts. Also, distrust yourself and your own opinions! Even the experts can’t fully understand (or predict) the market cycles, so don’t get hooked on anyone else’s advice (including me), since all of us are too often wrong.

Listen to everyone, but please don’t rely on stock recommendations whether from your broker, from your friends, from an investment newsletter, or from anyone who charges you for advice, or gets a commission.

If you are not putting in money which you will need to take out during the next year or two. Usually, just when you need your money back is when the market will be down. Being forced to sell is never pleasant.

If you invest your money gradually over time and take it out equally slowly. You should avoid trying to figure out stock market timing – when the market will be high or low. The best approach is to put money into the market steadily every month or every year, without trying to guess the future. That way, you will avoid the worst disasters and benefit from upward trends.

If you pick the right industries. A world expert in forest industry stocks once told me that picking the right time to buy forestry stocks was far more important than knowing which forestry stocks to buy. The same holds true for oil & gas stocks, automotive stocks, and for most other industries. However, since most of us are not expert enough to know exactly when to buy which industries, a diversification of stocks and a diversification of industries is a better approach.

If you pick the right countries in which to invest. Never get too patriotic about your own country when investing, because all major countries eventually have their ups and downs. In 2006, stocks from Canada, China, India and other rapidly developing countries have been booming. But this trend will not go on forever. Every national stock market has ups and downs. Diversify.

If you invest in stock market indexes of major countries or in industry sectors, which is now possible to do. Investing in indexes can dramatically reduce the commissions you pay, and likely improve your performance as well.

If you can figure out how to minimize both the stated and hidden commissions by brokers, advisors and fund managers, which can drastically reduce your returns. These costs come at 3 levels:

Buying, selling and administration fees from the broker who handles your stock transactions (Frequent trading is incredibly expensive, unless you trade online through a discount broker)

Annual asset management fees which are charged on mutual funds or investment funds of any type. These can be as high as 2 - 3% p.a., which I would never pay.

Hidden fees paid to your broker for selling you new issues of stocks and other investment products. These fees can be quite large. I usually avoid new issues.

Altogether these charges can range from 1% to 5% p.a. on the money you invest, which reduces your gains considerably. (I don’t like to pay over 1% per year and so I have much of my money in market index funds that cost me only a quarter of 1% per year for administration, and, with a fund manager whose combined charges are just over 1% p.a.);

If you avoid trying to pick out individual stocks unless you are the one person in 10,000 actually trained to do that – even professional stock-pickers rarely beat the market indexes for long, except for Warren Buffet.

(Picking out individual stocks can be a fascinating exercise if you have time, patience, and deep pockets. I would suggest the following approach. Try to find a local company which you know well; that has trustworthy management; that treats employees and customers well; that has consistent growth in sales and earnings; that has superior products at good prices; that has a unique niche in its market; then gradually buy some of their stock. I recommend against putting more than 5% or 10% of your money into any one investment. Regrettably, there are not many companies that meet these criteria, but they are often great investments.)

If you have very realistic expectations. Over 10 – 20 years, you could average up to 10% p.a. by owning a diverse portfolio of stocks (or indexes), but expect enormous swings in good years and bad years. Short term gains or losses mean little.

The allure of stocks is truly beguiling. If you or I could only pick out the right stock in a young company, we could potentially make a 10 or 100 times gain; $1,000 could become $10,000 or even $100,000.

For instance, you or I might potentially have picked Microsoft or any of the hundreds of companies which made that much for their early investors. Trouble is, for every big success, there seem to be thousands of stocks that either fail completely, or never do very well. Furthermore, if you buy into a huge success story near the top of the market (again using the Microsoft example) you might lose 20 – 60% on your money, even though the early investors in that stock have made a real killing.

There are a select few stock professionals who don’t just look at you as just an easy mark. I recently heard a quip from Henry Kissinger saying: “Unfortunately, 90% of the politicians spoil the reputations of the other 10%”. That statement would apply equally to investment advisors!

Stocks have better returns than bonds and other fixed rate investments in the long run, provided that you invest with discipline and diversify your holdings, both by geography and by industry. But remember the higher returns from stocks are compensation for taking more risks:

• risks in companies and their management;
• risks in industries;
• in countries and currencies;
• risks in the economy, both local and global.

At times, catastrophic developments virtually wipe out the value of not only one particular stock, but for entire industries, and even for some countries. I believe there is a small chance that we could see another global wipeout of equities, such as happened in 1928 – 1932. So don’t think stock returns are guaranteed!

Despite my necessary warnings about the risks, I really like investing in stocks (and in real estate) for long-term gains.