Back to school, back to fundamentals
Kids have been back to school for a month. It is a good reminder of what we are supposed to learn and take away from our years in a classroom. At its core, school teaches us fundamentals – how to think, write, talk, calculate, get along with others.
But just because we learned something years ago, doesn’t mean that we can’t get complacent. Take for example working out. I have been going to gym for years. I even earned my personal trainer designation. Yet, I found that I now have various muscle pains. I have gotten into bad habits that resulted in muscle imbalances, poor posture, etc. The solution? Back to “school”, back to fundamentals. I started to work with a personal trainer for the next few months to correct the bad habits and build new routines.
The same is true for investing. The last ten or so years have been go-go times in the stock market and housing market. You could buy almost any stock or any house and flip it for a profit. Easy as apple pie! But fundamentals matter – whether at school, in the gym, or in the market. And the stock and housing market slides have reminded us of this fact.
So, what are the fundamentals when it comes to investing? Here are four to start with:
Many investors worry about when to buy and when to sell – they try to time the market.
Timing the market requires the same type of luck as winning the lottery or at the casino. Statistics show that missing the ten best days out of the last twenty years would have cut your return in half! In the immortal words of Clint Eastwood’s character, Dirty Harry, ‘you feeling lucky, punk?’ For a long-term investor, buying at a few dollars less or more won't make a major difference to their portfolio. It is important to be in the game and let the power of compounding work to your advantage. A dollar-cost averaging approach – where you buy or sell a certain dollar amount every month or every quarter – removes the urge to time the market, the regret from buying or selling at the wrong time, and it pays off in the end. For example, say you invest $100 every month in investment XYZ. Today it is trading at $20 per share, so you have bought 5 shares. Next month, the price has gone up to $25 a share – so you bought 4 shares. But now you have a total of 9 shares which are worth $225 – you made $25 without trying to time the market. Time in the market is more important than timing the market.
Another key fundamental is diversification. Your grandmother probably told you not to put all your eggs in one basket. What she meant was to diversify – have your eggs in a bunch of different baskets, so if you drop one, you don’t break all your eggs. For investing, it means choosing investments in different companies, in different sectors, in different geographies. This year, investors in cryptocurrency, the US tech sector or the Russian stock market have experienced first-hand why diversification of your portfolio makes sense.
Understanding what you are investing in, how the company makes money and competes is another fundamental. In fact, Warren Buffett famously stayed out of investing in tech companies for years because he didn't understand the sector. Since then, he has been a big investor in Apple – may be his close friend Bill Gates, of Microsoft fame, helped him understand the sector better. Joking aside, many retail investors who jumped into cryptocurrency investments or meme stocks without understanding the business dynamics got hurt in recent months when the market moved against them.
The fourth fundamental is risk. There are many different types of risk when it comes to investing. The most talked about risk is volatility risk – how much the value of the investment moves up and down. If volatility is bad, you could choose savings accounts, because they have zero volatility. The problem? If you are counting on savings accounts to fund your retirement lifestyle, low interest rates mean you could probably run out of money. This is shortfall risk. It is not talked about as much as volatility risk, but the reality is that investing requires risk trade-offs – how much volatility risk are you willing to bear to deal with shortfall risk. There is no right answer, and each investor will need to answer this for him or herself. The answer will determine the right investment strategy.
Investing is simple but it is not easy. And like reading, writing or arithmetic, the fundamentals are important. In school, with workouts, or in investing, it always makes sense to go back to fundamentals.
For more lessons, check out my best-selling book Making Your Money Work: The Secrets to Financial Health