When the Going Gets Tough, Don't Lose Sight of the Fundamentals
Remember Why You Invested in Stocks in the First Place
There are many reasons you may have invested in stocks.
- You may be looking to grow your wealth through increasing capital and equity.
- You may want to generate income from dividends.
- You might want to accumulate a tidy nest egg to see through your retirement
- You may even have all of these goals in mind.
Notice that “losing money” isn't on the list, but it happens at least sometimes to even the shrewdest investor. Last year, the market posted record highs and nerve-shattering lows. If you want to reduce your risk of loss, always keep your eye on the fundamentals of investing before you pull the trigger on any new investment. Here is a quick review of some core ideas.
Know Your Strategy
Your goals change over time based on your financial situation, your stage of life and the economic climate. This means you should start by reviewing your goals. It may be just a quick mental review or you may want to crunch some numbers in a spreadsheet. Either way, your investment strategy should reflect your goals. It should also reflect your ability to deal with risk.
You may be comfortable with different degrees of risk at different times in your life. Some examples of how your goals may change over time:
- You need to manage risk carefully when you are facing retirement. You also need to provide enough growth to stay even with inflation. Growth that exceeds the inflation rate is even better.
- To increase wealth at any age, you may take more risk in return for a possible large reward. Just because you accept some risk doesn’t mean you are willing to throw money away, so look before you leap into a new investment.
The idea of having a defined strategy is to meet your goals while keeping risk at a level you can live with. You should always look for stocks that balance your need for returns with your ability to deal with risk. If you are nearing retirement without a nest egg, you may want to think twice before sinking all your money into penny stocks. If you are young and have money to play with, you can take more risk. You will have years to recover if the stock doesn’t pan out.
Benjamin Graham and David Dodd wrote an entire book on the topic of investment strategy. In their book, the authors laid out some basic rules and strategies for investing. According to them, preserving capital and managing risk should be the first rule for every investor. To help ensure that, they describe a method they called value investing.
Their theory uses a simple but potent concept for deciding on investments. The idea is to buy securities or other assets at less than they are currently worth. It sounds very simple. Unfortunately, as every investor knows, it is not always as easy as it sounds.
The authors wrote that book in 1934. You may be wondering if there are better, more modern theories of investing suited to today’s economic environment. After all, they wrote that book nearly a century ago.
Well, it is certainly possible that there is a better idea. But it isn’t likely that you will find one as simple or as relevant to every market.
Why You Should Use the Principles of Value Investing
Graham and Dodd’s book created the basis for modern investing strategies. The book is still in use as a textbook at universities and colleges. That’s not a bad record for a book more than 80 years old.
Many successful investors still swear by their ideas. Warren Buffett uses at least some of the book’s techniques. Buffett is a well-known advocate for the power of value investing.
Value investing is easy to explain but harder to use. Put simply, you must identify companies worth more than their market price. In theory, market price reflects the value of a company.
The market price of stocks doesn't always reflect hidden value. Finding companies with low earnings ratios is the easy part. Many sites post these lists on the Internet. You can find them with a simple search.
As you know, the real trick is to uncover companies with hidden potential that the rest of the market is ignoring. That’s the part takes some effort. In fact, it takes a lot of effort.
You could just read the research notes from any major investment firm. That puts you on a level playing field with every other investor in the market.
Reading mainstream research is not likely to uncover any hidden gems. The majority of the market will have read the same reports. That’s the biggest reason that the market price is the market price.
The secret sauce in value investing is to uncover information that other investors don’t know yet. That may take some digging. You will need to use research that other investors don’t read. You may need to dig into the details of each company’s annual report to find hidden nuggets of value. Examples might include
- The company is about to introduce a new product.
- A competitor is dropping a product line.
- Overlooked assets.
Take the time for due diligence before you plunk down your hard-won capital. It’s worth the time and effort.
Margin of Safety is a Core Fundamental
Finding company information takes a lot of time and effort. It doesn’t always pay off even when you think you’ve uncovered a winner. That’s where the margin of safety comes into play.
You want to invest in stocks where the true worth is much higher than the market price. This allows you to make your investment with little actual downside risk. The “hidden” value you identified during your research provides a safety net in case the company fails.
We all know that stocks rarely stay at exactly the same price for long. It is very likely that your target company’s market price will change. To a certain degree, the margin of safety protects you regardless of what the market does.
- If the market recognizes the company’s “true” value and the price goes up, you win. You can sell your shares at a healthy profit.
- If the company goes belly up, the “hidden” value that you identified will help to reduce or eliminate any loss.
Choosing investments with a large margin of safety reduces your risk. It may even improve returns. The margin of safety helps to reduce the effect of market changes. It reduces the risk of investment. You are maximizing the upside by betting on stocks with a low P/E. You are minimizing the downside because you are betting on stocks with hidden value.
Investing in stocks with a large margin of safety doesn’t always work. It can’t protect you from every risk. You might occasionally overlook or miss an important point while doing your research.
Even so, using margin of safety as a benchmark can help you to reach your investment goals. It can help conserve capital. It can reduce risk. Value investing is one of the most fundamental techniques that you can use when looking for a new investment opportunity.