We've discussed the so-called Refrigerator Problem; that the average American spends more time selecting the appliances in their kitchen than they do studying, learning about, analyzing, and making rational decisions regarding their retirement, investment portfolio, savings, and long-term wealth.
Nowhere is this more evident than the willingness of hardworking people, who would never leave $5 on a park bench, to throw a huge chunk of their life savings into a stock they barely understand, with no knowledge of what their shares represent, and no ability to calculate how much the company, and therefore the stock, is worth to a rational buyer.
I know, for example, that if I were considering investing in stock and the company generated $5.00 per share in profit, that it would grow at 7% for the next 5 years before leveling off to 4% thereafter, and that I wanted to earn 12% on my money, I could only achieve my return if I paid $98.50 per share or less. If I wanted to earn 15%, I couldn't pay more than $53.21. It's simply a matter of a few steps involving discounted cash flows. A few times a decade, I might see a great opportunity and have a chance to buy a lot of stock in a company with great economics, such as high returns on equity, little or no debt, hard-to-assail competitive positions, trademark, patent, and copyright protections, and shareholder friendly management.
If you don't know how to do those calculations, you probably have no business investing your money in stocks. Instead, a better option might be low-cost index funds that represent ownership in a wide basket of securities. That takes the guesswork out of investing and helps ensure you earn average returns. By now, you should know that for investors, being average is underrated. According to one Morningstar study, during a time period when markets generated 10% returns, investors only made 3% on their money because they kept switching between mutual funds and other securities!
Don't be like those people, taking risk while still earning a pathetic return. If they had been content to ride out the ups and downs of equity ownership, history has shown they had a decent chance of earning a good after-tax, after-inflation return that could have increased their real purchasing power. In the end, that is what counts: The number of cars, vacations, televisions, hamburgers, sweaters, watches, doctor visits, charitable donations, or magazine subscriptions you can buy. Throw in the towel, become average, and strive to do well. Paradoxically, that alone will put you in the minority.
What If You Want to Learn How to Value a Business and Invest in Stocks?
If you are like me and you love valuing companies, assets, real estate, bonds, stocks, and other securities, there are a few subjects you need to master. The journey will take years but the tool set can serve you well in many other areas of life. There are four key disciplines you need to make a part of your intellectual repertoire:
- Finance (compounding and discounting cash flows, the time value of money, APR, APY, CAGR, and IRR formulas)
- GAAP (standard accounting rules, the language of business, that help you figure out the "real" numbers to use in the formulas from the first bullet point)
- Portfolio Management (putting together a collection of assets that takes advantage of tax breaks, your own personality and preferences, reflects your values, etc.)
- Economics (understanding how a nation's economic policies effect the assets within that nation)
Break them down into the component parts and, even if you think you already know something, don't take it for granted and study it, anyway. I can't tell you how often I come across investors that have gaps in their understanding of stocks, bonds, accounting, finance, and economics, sometimes believing that a stock dividend actually increases their wealth (they don't) or that a cash dividend, which does put money in your pocket, counts as an expense on a company's income statement (it doesn't).
If you get overwhelmed, never forget that every great investor began exactly where you are. None of us were born with a knowledge of anything, whether you are a heart surgeon or a portfolio manager. Also, never forget that you are free to walk away, hang up your hat, and resort to simple low-cost broadly diversified index funds.
In fact, I would urge most of you to do just that. Be normal. Be average. Invest for the long-run, reinvest your dividends, take advantage of tax breaks, and build a career that results in higher household income with each passing year. That recipe has worked for generations and it seems reasonably likely to continue working in the future, given enough time.
Originally published on About.com on December 30th, 2011 at 3:31 p.m., Central Standard Time
