Investment and speculation must be kept totally separate, in the mind and in the wallet. Just as intelligent investment exists, there is also intelligent speculation.
It’s a matter of choice. What is absolutely wrong, is the misunderstanding: to think that you are investing when you are speculating instead.
The smart speculator must work by looking forward, anticipating market trends. It must do the opposite of the smart investor, who instead bases his analyzes on what does not fluctuate, which remains constant over time.
For this it is necessary to have a satisfactory knowledge of the history of the stock market in which you want to operate.
However, you should never dedicate more than 10% of your funds to speculation, in order to protect yourself against losses that can be catastrophic.
The smart investor and inflation
The smart investor worries about inflation and watches over the market to protect himself from the unexpected. It is essential to keep in mind that there is never a perfect time to “be in one asset”, the diversification of the portfolio is strategic.
The characteristics of a defensive investor
The defensive investor is one who does not have the time or the will to make the necessary efforts to be an enterprising investor. His will be a passive approach: he will seek conservative investments that require minimal effort in portfolio management, research and selection of individual investments.
Unlike the enterprising investor, it will not expand its potential beyond conservative and stable choices: the amount of risk that you should accept depends on the amount of intelligent effort that you are capable and willing to spend, and you must be prepared to accept a return. average.
The defensive investor can divide his portfolio equally between stocks and bonds. The rebalancing of the portfolio can be rethought at times when valuations significantly indicate the convenience of a different allocation of assets with respect to the 50-50 target.
The two main advantages of equities are protection from inflation and a higher rate of return than long-term bonds. These advantages can be wasted if the investor pays too high a price for his shares.
These are the characteristics that must guide the defensive investor in the creation of his portfolio:
- adequate diversification : from 10 to 30 companies;
- large companies and sound financial condition;
- dividends (20 consecutive years of dividend payment) and growing earnings;
- limit the purchase price you are willing to pay:
- moderate price / earnings ratio: the share price must not exceed more than 15 times the average earnings of the last 3 years;
- moderate price / book value ratio: the price of the shares must not exceed 1.5 times the book value of the assets.
Especially if he is a beginner, the smart investor never tries to beat the market, but focuses on understanding the difference between price and value. In the long run, knowledge, discipline and the ability to pay reasonable prices will make the difference.
The defensive investor can choose to invest in investment funds. These investment vehicles provide a convenient means of saving and investing, from which to expect average results.
The advantage of acting through an investment fund is to diversify your portfolio economically effectively with a little effort.
The enterprising investor is his strategy
The enterprising investor has the time and experience (or enjoys adequate guidance) in investing which allows him to expand the possible universe of opportunities beyond the conservative sphere.
His is an active approach, which requires constant attention and monitoring. The enterprising investor is willing to make the necessary efforts required for dynamic portfolio management, research and selection of individual investments. Greater profits can be obtained from the enterprising investor in exchange for his dedication to these activities.
In general, the enterprising investor must not:
- investing in low-rated bonds;
- investing in new issues;
- invest in stocks with little history (especially if they are foreign).
The objective of the enterprising investor is to obtain a rate of return above the average, to achieve it he will have to perform four activities:
- buy with low market to sell with rising market (tactical asset allocation);
- buy growing stocks;
- buy below the market value (bargain purchase), such as – for example – the case of an established company that has a price per share lower than the historical average price;
- buy “” special occasions “”: you must be able to identify particular situations, such as – for example – the case of a small company that is about to be acquired by a very large one.
There is no middle ground between the defensive and the enterprising investor. If you are unwilling to devote the time and energy you need to your wallet, better choose to be defensive.
For the enterprising investor, success comes by honing the ability to understand which stocks are underestimated, that is, they have a market price that does not fully reflect their value. For this analysis, the indicators to follow are:
- robust financial condition;
- gain stability (positive in the last 5 years);
- current dividend payment;
- current earnings higher than those of the previous year.
How should an intelligent investor behave towards fluctuations?
Market fluctuations can be wild: the investor runs the risk of not being focused on the value of the shares as an entrepreneur has to do, but of allowing emotions to change his attitude in the decisions to sell and buy.
Many devote their attention to indicators that – they believe – can predict the future, but it is absurd to think that “common” investors can make money with market forecasts.
The smart investor uses prices as a parameter to make buying and selling decisions: he buys stocks when they are priced below their fair value and sells stocks when they exceed the fair value.
Mr. Market’s parable for being an intelligent investor
He thinks he has a partner called Mr. Market who offers a different price every day at which you can buy his or sell shares of the company to him.
The smart investor has done his homework and knows the intrinsic value of the company’s shares. When Mr. Market wants to sell its shares at prices below intrinsic value, the smart investor chooses to buy.
When Mr. Market is willing to buy securities at a price above their fundamental value, the smart investor sells. This is the discipline to follow: as an intelligent investor, you are only doing business when this business is to your advantage; and this is all.
The smart investor must be able – financially and emotionally – to benefit from “disconnected” prices from their real value. It is important to be prepared for the inevitable market fluctuations, to avoid owning securities that are priced higher than their real value, to be aware of excessive exchanges and irregular fluctuations in performance.
Smart investors and advisors
“A lot of bad advice is given for free.” The consultant’s most important goal should be to save the investor from his worst enemy, himself.
A good consultant will help keep emotions in check, especially in important moments. Instead of selling in panic, the well-advised smart investor will be ready to buy when prices have fallen.
Instead of following the crowd, who could buy at prices far above intrinsic value, they will be able to wait and look for better deals elsewhere.
The smart investor is secular
In selecting the investment, the investor must be secular. This means that the analysis of past performances must guide him in his judgments, there is no room for emotions, there is no room for conjectures: the greater the quantity of hypotheses that must be made about the future, the greater is the possibility that an error of assessment is made.
In bond analysis, the most reliable benchmark for security is the profit coverage test. How many times, and based on how much, the company’s earnings covered expenses for a considerable period of time (at least 7 years).
In the analysis of ordinary shares, the company’s valuation is compared with the current price to determine whether the purchase is inviting. Obviously an investor should look for a safety margin. In other words: buy at a lower figure than the real value.
Average future earnings should be the main indicator when considering value. However, the selection of investments should also take into account the required rate of return (capitalization rate).
The smart investor must be adamant in refusing to give importance to short-term gains: the more an analysis is based on them, the higher the risk, the more attention and caution is needed. The most reliable indicator of the company’s future health is medium-term earnings (7/10 years).
Evaluate convertible bonds
The buyer of convertible bonds usually waives the return and accepts more risk in exchange for the conversion right. However, the company could go against the benefits of common shareholders for the benefits of its future growth.
The truth is that convertible bonds need to be assessed individually on a case-by-case basis.
Shareholders must have an active role in the company
Shareholders are called to take an active role, to feel themselves owners of the company: the management that gives good results must be rewarded, while the one that produces poor results should be questioned and contested. The smart investor holds the board members accountable.
Their management decisions, dividend policies, repurchase programs and the general commitment to pursuing the interests of the shareholders must therefore be analyzed and taken into consideration as key factors in assessing the quality of the investment.
The “safety margin”
These are the three most important words. The safety margin is also called “the secret of solid investment” and “the central investment concept”.
What is it about? The safety margin for an investment is the difference between the real value of the share and the purchase price. The goal of the smart investor is to pay the securities less (hopefully, much less) of the real value.
The greater the distance between the two values, the greater the margin of discretion that allows you to absorb the effects of negative conditions before they turn into a loss of money. If the conditions are as good as expected or even better, the profits are exponentially higher precisely based on how large the starting margin is.
Virtually anyone, with a little knowledge and very hard work, can analyze the past. The importance of this exercise is clear: since not even the best analysts are able to predict the future in a consistent and accurate way, the safety margin function is to make these predictions unnecessary.
In other words, having a security buffer allows you to invest even on the basis of inaccurate forecasts.
The right purchase price to pay
As already mentioned, the safety margin is a function completely dependent on the price paid. Each security has a price that guarantees a safety margin that makes it inclined to purchase.
The key point of smart investment is knowing how to determine what this purchase price is and having the discipline to invest only at a price equal to or lower than it. This is where the main difficulty lies, it is essential to know how to resist the temptation (and risk!) Of paying too high a price for a good quality investment.
You have to pay close attention: it is easy to draw wrong conclusions if you rely on the profitability of a company due to some good years. A true safety margin requires sufficient time.
The purchase of growth stocks is not recommended, analysts tend to project the future earnings of growth companies at rates far above the average, leaving little room for errors or changes in conditions.
Growing stocks should only be purchased when the price provides a safety margin based on conservative projections.
The smart investor diversifies
Diversification is a fundamental part of smart investment, and it is through it that the safety margin for the portfolio as a whole is built.
We’ve turned the odds in our favor by making sure that every single investment has a safety margin. However, regardless of how well we have done this work, some of our investments will fail to meet expectations.
Adding the criterion of diversification means placing yourself in the condition of having combined earnings that will be much higher than any losses. The more opportunities we are able to meet our security requirements, the more likely it is that our portfolio, as a whole, will yield above average earnings.