Foundational Investing Series: Part 1
Click to jump to any section:
- You Can Keep It Simple As Long As You’re Disciplined
- Investing 101: Things You Need To Know
- The Market Goes Through Cycles
- Staying Invested Leads to the Most Gains
- S&P500 vs. Hedge Funds
- Individual Stocks May Contract Despite Improving Performance
- Large Caps vs. Small Caps
- Growth Investing vs. Value Investing (Contrarian Investing)
- Short at Your Own Risk: Long vs. Short Selling
- Letting Your Winners Run & Cut Your Losers Short: Use Stop-Loss Orders
- Investing Philosophy
- Common Investing Mistakes
- Conclusion
You Can Keep It Simple As Long As You’re Disciplined
When it comes to investing, simplicity can often be the key to success. While the financial world may seem complex and intimidating, the truth is that you don't need a complicated strategy to achieve your investment goals. In fact, many successful investors have found that keeping things simple and sticking to a disciplined approach can yield excellent results over the long run.
One fundamental principle to remember is that stocks tend to go up over time. This is because economies tend to grow their GDP. Combine this with currency inflation and asset prices will increase over the long run. As such, investing in the stock market can be an effective way to participate in the long-term growth of the economy.
For individual investors, exchange-traded funds (ETFs) like SPY, IVV, VOO (tracking the S&P 500), QQQ (tracking the Nasdaq 100), and DIA (tracking the Dow Jones Industrial Average) offer a simple and efficient way to gain exposure to the stock market. While the S&P 500 represents a broad cross-section of the U.S. stock market, the QQQ focuses on technology companies listed on the Nasdaq exchange, and the DIA tracks 30 large-cap industrial stocks. Each ETF has its own unique benefits and may appeal to investors with different preferences and investment objectives.
Even Warren Buffett, an icon in the investing space, has famously recommended investing in the S&P 500 index. However, for Buffett, managing Berkshire Hathaway Inc.'s massive assets under management (AUM) of billions of dollars presents unique challenges. Holding an ETF like SPY would not be practical for Buffett, as his large holdings could significantly impact the ETF's price if he were to buy or sell shares. But he said that he would do it, so why wouldn't this work for you?
Just Keep Buying Consistently: The Dollar Cost Averaging Strategy
Dollar Cost Averaging (DCA) is a proven strategy that's both simple and effective. With DCA, you invest a fixed amount of money at regular intervals, regardless of market conditions. This approach can help smooth out the impact of market volatility and reduce the risk of investing a large sum of money at the wrong time.
Pairing DCA with an S&P 500 ETF (such as SPY), can provide a straightforward and low-cost way to participate in the stock market's long-term growth.
The Power of Compounding
One of the most powerful concepts in investing is the power of compounding. Compounding occurs when your investment returns generate additional returns over time. Let's illustrate the impact of compounding with three examples:
- $100 a month over 30 years: If you were to invest just $100 a month over 30 years, assuming an average annual return of 7%, you could accumulate over $186,000, adjusted for inflation.
- $500 a month over 25 years: Investing $500 a month over 25 years, with the same average annual return of 7%, could result in a portfolio worth over $425,000, adjusted for inflation.
- $1000 a month over 20 years: Finally, investing $1000 a month over 20 years, again with an average annual return of 7%, could lead to a portfolio exceeding $601,000, adjusted for inflation.
These examples highlight the incredible potential of compounding and the importance of starting to invest as early as possible to maximize its effects.
Watch Your Spending & Invest For Your Future
It's important to remember that investing is not just about how much you make, but how much money you invest. A study has shown that framing your investment goals in terms of putting money aside for a loved one can lead to higher levels of savings. By thinking of your investments as a way to secure your financial future and provide for your loved ones, you may find it easier to stay disciplined and committed to your investment plan.
"It’s not just about how much you make, but how much money you invest."
Consider your monthly spending habits and where your money goes. On average, most people allocate a significant portion of their income to essentials such as housing, transportation, food, and healthcare. These essential expenses typically consume a large percentage of monthly earnings, leaving little room for discretionary spending.
However, it's essential to recognize that there are opportunities to reduce expenses and allocate more money towards savings and investments. For example, cutting back on non-essential expenses such as dining out, entertainment, and luxury purchases can free up additional funds for investing. By prioritizing your financial goals and making conscious decisions about how you spend your money, you can maximize your savings potential and accelerate your journey towards financial independence.
Consider the following breakdown of typical monthly spending percentages:
By identifying areas where you can cut back on expenses and reallocating those funds towards savings and investments, you can make significant strides towards achieving your financial goals. Remember that every dollar you save and invest today has the potential to grow exponentially over time, thanks to the power of compounding.
Ultimately, by reframing your mindset and viewing investing as a means to secure your financial future and provide for your loved ones, you can stay disciplined and committed to your investment plan. By making smart financial decisions and prioritizing long-term wealth accumulation, you can build a brighter financial future for yourself and those you care about.
Investing 101: Things You Need To Know
As you start on your investing journey it's important to understand a few important foundational principles. Below are a few things that you need to know and that you should always keep in mind when you are investing.
The Market Goes Through Cycles
It's crucial for investors to understand that financial markets operate in cycles. Periods of valuation expansion, where stock prices rise relative to earnings, are often followed by periods of contraction, where prices decline. While market downturns can be unsettling, it's essential to remember that they are a natural part of the investing landscape.
It's a well-known adage that the next crisis is always around the corner. However, history has shown us that markets have a remarkable ability to recover from downturns and reach new highs. For example, during the 2008 financial crisis, the S&P 500 lost around 50% of its value. However, by March 2013, it had fully recovered and surpassed its pre-crisis peak.
Here's a table illustrating multiple examples of market contractions:
| Crisis | S&P 500 Peak | S&P 500 Trough | Peak to Trough Decline |
| Dot-com Crash | 1,552.87 (Mar 2000) | 768.63 (Oct 2002) | -50.5% |
| Global Financial Crisis | 1,565.15 (Oct 2007) | 676.53 (Mar 2009) | -56.8% |
| COVID-19 Pandemic | 3,386.15 (Feb 2020) | 2,237.40 (Mar 2020) | -34.0% |
Staying Invested Leads to the Most Gains
A study conducted by JP Morgan Asset Management found that missing out on the top 10 trading days in the S&P 500 over a 20-year period (1999-2018) would have resulted in a significant loss of returns. For example, an investor who stayed fully invested during this period would have earned a total return of 210%. However, if they missed the top 10 trading days, their total return would have dropped to just 60%.
While timing the market is notoriously difficult, it's important to remember that markets tend to rebound over time. Investors who remain patient and stay invested during downturns are often rewarded as markets recover and reach new highs. By maintaining emotional discipline and adhering to a well-thought-out investment plan, investors can navigate market cycles with confidence and achieve their financial goals.
S&P500 vs. Hedge Funds
The S&P 500 index has a remarkable track record of outperforming actively managed funds over the long term. According to the latest S&P Dow Jones Indices SPIVA research report, a staggering 92-95% of actively managed funds failed to beat their passive index benchmarks over a 15-year period. Furthermore, over a shorter 5-year period, 80% or more of actively managed funds also failed to outperform their benchmarks. These findings underscore the difficulty of consistently beating the market through active management
Though it should be said that while hedge funds and the S&P 500 index may both aim to generate positive returns for investors, their investment strategies and goals can differ significantly. Hedge funds often employ sophisticated strategies and may prioritize risk management and capital preservation over outright returns. They may focus on achieving a favorable return per unit of risk, assessing performance metrics like Sharpe ratios to evaluate risk-adjusted returns. Unlike the S&P 500, which aims to replicate the performance of the broader market, hedge funds may employ strategies such as short selling, derivatives trading, and alternative investments to hedge risk and potentially generate positive returns in all market conditions.
Individual Stocks May Contract Despite Improving Performance
Another thing to consider is that valuations may contract while a company’s performance is improving. One example fitting that description is IBM (International Business Machines Corporation) in the early 2010s. During this time, IBM underwent a strategic shift, transitioning away from hardware and into higher-margin software and services. As part of this transition, the company invested heavily in areas such as cloud computing, data analytics, and artificial intelligence.
Despite improvements in revenue and profit driven by these strategic initiatives, IBM's stock saw its valuation multiples contract. This contraction was primarily due to concerns over the sustainability of IBM's growth trajectory and the company's ability to fully capitalize on emerging technologies.
Investors worried that IBM's legacy businesses, such as hardware and traditional IT services, were declining faster than the growth in its newer, higher-margin segments could offset. Additionally, competition in the cloud computing space intensified, with rivals like Amazon Web Services (AWS) and Microsoft Azure gaining market share rapidly.
As a result, even as IBM's financial metrics improved, its stock valuation faced downward pressure, reflecting investor skepticism about the company's long-term growth prospects amidst a changing competitive landscape.
Large Caps vs. Small Caps
The thing about Large Caps (or companies with big market capitalization) is that they typically have higher valuations as measured by metrics like the Price-to-Earnings (P/E) ratio. This is partly due to their larger market capitalization, making them more attractive to institutional investors that have strict liquidity requirements. The increased demand for large-cap stocks can create a "scarcity premium" driving up a select few stocks' valuations that match the investment criteria for institutional buyer compared to smaller-cap stocks.
In addition, large-cap companies often boast stronger financials compared to their smaller counterparts. They typically have established business models, extensive customer bases, and robust sales and distribution processes. This financial stability gives large-cap stocks an edge, as they are better equipped to weather economic downturns and financial crises.
While large-cap stocks may have slower growth rates compared to small-cap stocks, they still have avenues for growth. Large-cap companies can leverage strategies such as share repurchases and may reinvest to fuel book value growth. This ability to grow their earnings per share despite financial constraints contributes to the appeal of large-cap stocks for investors.
While small-cap stocks may offer higher growth potential, identifying hidden gems in this segment of the market can be challenging. Small-cap companies often lack the financial metrics compared to large caps and are often performing with negative earnings. Furthermore, they may lack the analyst coverage of their larger counterparts, making it difficult for investors to assess their true value and growth prospects.
Growth Investing vs. Value Investing (Contrarian Investing)
Investing strategies can be broadly categorized into two main philosophies: growth investing and value investing. Let's explore the differences between these two approaches and how they complement each other in building a diversified investment portfolio.
Growth investing focuses on identifying companies with strong growth potential, typically in sectors such as technology, healthcare, and innovation. Investors in growth stocks seek companies that are rapidly growing their revenues, often prioritizing revenue growth and market share over current profitability. Growth investing is driven by the belief that these companies will continue to outperform the market as they capitalize on emerging trends and disrupt traditional industries. An important thing to note about growth stocks is that they tend to be valued higher in terms of Price to Earnings Ratio or Price to Sales Ratio. An explanation for this phenomenon is that the market will value growth companies on a forward looking basis which means a company's is based on their future value instead of their current value.
Value investing, also known as contrarian investing, revolves around finding undervalued stocks trading below their intrinsic value. Value investors seek out opportunities in companies that are temporarily out of favor or misunderstood by the market, often due to short-term challenges or negative sentiment. By focusing on fundamental analysis and identifying stocks trading at a discount to their true worth, value investors aim to generate long-term capital appreciation as the market recognizes and corrects the undervaluation.
While growth investing and value investing may seem like opposing philosophies, they can be complementary when used together in a diversified investment portfolio. Pairing growth stocks with value stocks allows investors to benefit from the strengths of each approach while mitigating risks. Growth stocks offer the potential for high returns and capital appreciation, while value stocks provide stability and downside protection during market downturns. By diversifying across both growth and value investments, investors can achieve a balanced portfolio that smoothens out volatility and delivers consistent returns over time.
Short at Your Own Risk: Long vs. Short Selling
Taking long positions and short selling represent contrasting approaches to the stock market, each with its own risks and rewards. While long-only investing is more commonly practiced, short selling introduces a different dimension of risk and complexity.
Long-only investing involves buying stocks with the anticipation of price appreciation, while short selling entails selling borrowed shares with the aim of profiting from a decline in the stock price.
The thing to note here is that short selling carries inherent risks, exposing you to potentially unlimited losses if the stock price rises significantly. A good rule of thumb is to keep your short position sizes smaller, for example you could short at 0.5x the size of a comparable long position to mitigate risks.
One common strategy that's frequently employed by hedge funds is a 130/30 portfolio, where 130% of assets are long exposure and 30% are shorts. Incorporating both long and short positions allows funds to potentially profit from both rising and falling stock prices.
You may choose to short sell for various reasons, such as:
- Belief that a stock is overbought or overvalued.
- Anticipation of declining growth due to factors like loss of customers or declining revenue prospects.
Despite the complexities and risks associated with short selling, it can serve as a strategic tool for investors seeking to capitalize on overvalued stocks, hedge against market downturns, or profit from companies with weak fundamentals. However, prudent risk management is paramount, including limiting the duration of short positions and utilizing stop-loss orders.
Letting Your Winners Run & Cut Your Losers Short: Use Stop-Loss Orders
In investing, there are two fundamental principles: letting your winners run and cutting your losers short. These principles, though simple in concept, are critical for maximizing returns and managing risk in your investment portfolio.
Allowing your winning investments to continue growing can significantly enhance your overall returns. When you identify a stock that is performing well and has strong growth potential, it's important to resist the temptation to sell too soon. Instead, consider holding onto your winning positions and allowing them to compound over time.
On the flip side, it's essential to recognize when an investment is not performing as expected and take decisive action to cut your losses. Allowing losing investments to linger in your portfolio can lead to further losses and hinder overall portfolio performance.
Use Stop-Loss Limit Orders
Whenever you buy a stock it's wise to establish predetermined stop-loss levels. Then if a stock's price falls below the stop-loss level, it will automatically sell the position to limit losses.
Investing Philosophy
One of the great things about investing is that you can go as deep as you want into learning about it. Whether you're just starting out or have years of experience under your belt, there's always something new to discover and explore. By dedicating time and effort to researching investments, analyzing market trends, and studying financial metrics, you can gain a deeper understanding of how the markets work and identify opportunities for higher returns.
Put In The Work, and You'll Reap The Rewards
When it comes to investing, there's a popular saying: "Put in the work, and you'll reap the rewards." This couldn't be truer. While it's tempting to seek quick and easy investment strategies, the reality is that success in investing often requires dedication, effort, and a willingness to continually learn and adapt.
The more time you spend researching and analyzing companies, the more confident you'll become in your decision-making process. Confidence is essential in investing, as it allows you to stick to your investment strategy even when the markets are volatile or uncertain. By having conviction in your investment thesis and staying disciplined in your approach, you'll be better positioned to weather market fluctuations and stay focused on your long-term goals.
Ultimately, investing is not a one-size-fits-all endeavor. What works for one investor may not work for another, and there's no shortcut to success. However, by putting in the work, continually learning, and staying disciplined in your approach, you can increase your chances of achieving higher returns and building wealth over time.
Emotional Discipline, Patience & Long-term Perspective
Successful investing requires more than just financial acumen—it also demands emotional discipline. The ability to remain calm and rational in the face of market irrationality is essential for long-term success. As we've learned from history, crises are a natural part of the market cycle. However, they also present opportunities for recovery and growth. By maintaining a patient outlook and focusing on the long term, investors can weather short-term market fluctuations and capitalize on the potential for future gains.
One of the key reasons for maintaining patience is the recognition that, over the long run, the markets tend to go up. Despite periodic downturns, economic growth driven by increases in GDP and inflation typically leads to upward trends in stock prices over time. This long-term upward trajectory reflects the resilience and adaptability of the economy and underscores the importance of taking a patient approach to investing.
Additionally, having a long-term vision allows you to withstand the emotional rollercoaster of market volatility. Rather than reacting impulsively to short-term price movements, if you have a deep understanding of market dynamics and are confident in your investment decision, then you can avoid making decisions based on fear or greed.
While the allure of quick profits and overnight success may be tempting, the reality is that investing is a long-term endeavor that requires patience, discipline, and a clear understanding of the risks involved.
Another common misconception among investors is the expectation of consistently high returns. While it's true that the stock market has historically delivered attractive returns over the long term, it's essential to recognize that these returns come with inherent volatility and risk. In reality, the stock market experiences periodic downturns and fluctuations, and you should be prepared for the possibility of temporary losses along the way.
For example, let's consider the historical average annual return of the S&P 500. Over the past century, the S&P 500 has delivered an average annual return of around 7-8%. However, this average masks significant year-to-year variability, with some years seeing double-digit gains and others experiencing losses. By setting realistic expectations and understanding that market returns can vary widely from year to year, investors can avoid becoming disillusioned during periods of underperformance.
Furthermore, it's essential to recognize that investing involves a degree of uncertainty and unpredictability. While thorough research and analysis can help mitigate risks, there are no guarantees when it comes to investing. Even the most promising investments can underperform or experience setbacks due to unforeseen events or changes in market conditions. By acknowledging the inherent uncertainties of investing and preparing for the possibility of adverse outcomes, you can better manage your expectations and avoid making rash decisions based on short-term fluctuations.
Invest in What You Know
Investing in what you know is a fundamental principle endorsed by renowned investor Peter Lynch. This philosophy emphasizes the importance of staying within your circle of competence when making investment decisions. By focusing on industries, companies, and products that you understand well, you can leverage your knowledge and expertise to make informed investment choices.
Peter Lynch, known for his success as manager of the Magellan Fund at Fidelity Investments, believed that individual investors had a significant advantage over institutional investors due to their firsthand knowledge of consumer behavior and industry trends. He often cited examples from everyday life to illustrate his investment thesis, such as his investment in Dunkin' Donuts after observing long lines at the company's outlets.
Lynch's philosophy can be summarized in his famous quote: "Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it." This underscores the importance of investing in simple, easy-to-understand businesses with sustainable competitive advantages.
Investing in what you know offers several benefits. It reduces the risk of making uninformed investment decisions based on unfamiliar industries or companies, allows you to capitalize on your knowledge and expertise, and gives you confidence in your investment decisions, essential for long-term success in the market.
In conclusion, following the "invest in what you know" philosophy, as advocated by Peter Lynch, can lead to better investment outcomes. By staying within your circle of competence and leveraging your understanding of the market, you can enhance your chances of success in the stock market.
Below is great talk by Peter Lynch that we recommend (starts at around the 9min mark):
The More You Analyze, The More You Understand
One key principle to grasp early on is that the more stocks you analyze, the more your understanding of stocks grows.
Imagine each stock as a piece of a puzzle that forms the larger picture of the market. By analyzing multiple stocks, you start to see patterns, trends, and correlations that deepen your comprehension of how the market functions. Each company you research provides insights into different industries, business models, and market dynamics.
Moreover, analyzing a variety of stocks exposes you to the why's behind the metrics. For example, Amazon famously had negative earnings for a long time before they turned profitable, but since they were growing at such a rapid pace it was an attractive investment for investors. This exposure to a variety of stocks allows you to develop your own investment style and refine your decision-making process over time.
Research & Read
Successful investors, including Warren Buffett, emphasize the importance of continuous learning and research in the world of investing. Buffett, known for his voracious reading habits, reportedly spends about 80% of his day reading. This dedication to learning underscores the value of acquiring knowledge and staying informed in the investment landscape.
Increasing your investing skills and knowledge is a gradual process that can be achieved one step at a time. A great way to start is by delving into:
- Reports: Read companies' quarterly and annual reports which easily accessible on the stock pages here at Streamlined Finance. These reports provide valuable insights into a company's financial performance, strategy, and outlook.
- News: Stay on top of the latest news and developments for companies to gain valuable insights into how a company changes, performs and operates.
- Press Releases: Keep an eye on company press releases to stay informed about important announcements and developments.
- Analysts: Pay attention to independent analysis from analysts to gain additional perspectives on market trends and investment opportunities.
Instead of trying to cover all companies, focus on your circle of competence—the industries and companies you understand best—and dive deep into understanding their fundamentals.
Comparing different sectors and analyzing their metrics can provide valuable insights into industry trends and benchmarks. Some sectors may have higher profit margins than others, and understanding these dynamics can help you identify investment opportunities.
For foundational knowledge in investing, consider reading classic books such as:
- The Intelligent Investor by Benjamin Graham
- One Up on Wall Street by Peter Lynch
These timeless works provide invaluable insights into fundamental investment principles and strategies.
It's important to recognize that mistakes are an inevitable part of the learning process. View these mistakes as tuition fees paid for valuable lessons that will ultimately contribute to your growth as an investor. Remember, learning is not always linear, but as long as you're continuously expanding your knowledge and skills, you're on the path to becoming a successful investor. Anyone can succeed in investing with dedication, patience, and a commitment to lifelong learning.
Common Investing Mistakes
In the world of investing, certain missteps can significantly hinder progress and lead to undesirable outcomes. Let's explore some of these critical errors and how to navigate around them effectively.
Reliance on External Advice
A common pitfall for investors is placing too much trust in external advice without conducting thorough research. While seeking insights from trusted sources is valuable, it's essential to complement external perspectives with personal due diligence. Relying solely on recommendations can result in ill-informed decisions and missed opportunities.
Let Your Emotions Rule You: Fear & Greed
Emotions play a significant role in investment decisions, often leading to suboptimal outcomes. Fear can prompt investors to panic sell during market downturns, while greed can drive them to chase after unsustainable gains. By maintaining emotional discipline and adhering to a well-thought-out investment strategy, investors can avoid falling victim to these emotional traps.
Chasing Performance: Buying at the Top
The allure of chasing high-performing assets can be tempting, but it's a risky endeavor. Jumping into investments solely based on past performance can lead to buying at inflated prices and suffering from subsequent downturns. Instead, investors should focus on fundamentals and long-term prospects rather than chasing short-term trends.
Reluctance to Cut Losses
Holding onto losing investments in the hope of a turnaround is a common mistake known as "anchoring." However, failing to cut losses can prevent investors from reallocating capital to better opportunities and lead to further losses. It's essential to recognize when an investment thesis has failed and take decisive action to minimize losses.
Wrong Market Timing
Attempting to time the market by predicting short-term price movements is notoriously difficult and often counterproductive. Investors who engage in market timing risk missing out on the best-performing days, which can have a significant impact on overall returns. Instead, focus on maintaining a disciplined investment approach and staying invested for the long term.
Lack of Diversification
Failing to diversify investment holdings leaves investors vulnerable to undue risk. Concentrating all capital in a single asset or sector can amplify losses if that area underperforms. Diversification across different asset classes, industries, and geographic regions is essential for mitigating risk and preserving capital over the long term.
In summary, steering clear of these critical errors is essential for successful investing. By conducting thorough research, maintaining emotional discipline, avoiding performance chasing, cutting losses when necessary, staying invested for the long term, and diversifying portfolios effectively, investors can enhance their chances of achieving their financial goals.
Conclusion
Our goal has been to provide you with the essentials that sets you up for success in your investing journey. This article focused on the right approach, philosophy, and mindset required to become a successful investor as well as by providing you some basic knowledge that you need to know as an investor.
This article marks the first part of our three-part foundational series, designed to equip you with the fundamental knowledge you need to become a successful investor. In the next parts, we'll cover the investing process that provides practical strategies for finding, analyzing, and comparing stocks.
Remember, investing is a journey, and each step you take brings you closer to financial success. Keep learning, stay disciplined, and be proactive in managing your investments. With dedication and a commitment to lifelong learning, you have the potential to build a prosperous financial future.
~ Team Streamlined
The Foundational Investing Series: