Over the years, I’ve had many family members and friends ask me which stocks they should buy. While in the past I answered by naming a few stocks that I thought were of good value, after some time I realized that I was actually doing them a disservice. Firstly, I could be wrong. If I am wrong, I can correct it within my stock portfolio quite easily, but I have no control over whether they do the same. Moreover, I have found that many people do not like selling stocks and taking losses as it is painful to do so, which worsens their portfolio’s performance. Secondly, I have no control over how much of the stocks they buy. If the stocks I have suggested become a huge part of their portfolio due to inadequate diversification and a few of those stocks perform poorly – and they do not cut their losses – their portfolios could suffer tremendously. Thirdly, managing a stock portfolio is an ongoing affair. Keeping up to date with the companies’ financial statements, valuations and future prospects, cutting losses, taking profits, rebalancing the portfolio – these all require a lot of effort and time. It is practically impossible for me to inform them whenever I make any changes to my own portfolio, and moreover, they may not even make the changes due to a lack of time, inertia, or because they hope that their stock prices will recover/go even higher.
These days I am not of the opinion that most people should be picking their own stocks. In my conversations with stock investors, I usually find that they do not have a proper methodology to determine when they should buy and sell a stock. They also usually take too much risk to try to get better returns in the short term, such as by inadequately diversifying their portfolios. Most do not even measure their investment performance accurately! Lastly, most do not have the time required to monitor and manage their stock portfolios.
In my opinion, you should only really consider picking your own stocks if you are able to do the following:
1. Be Able To Estimate The Fair Price Of A Company’s Shares
If you invest in a great company at an expensive price, that’s probably not going to be a good investment. Singaporeans will do a fair bit of studying when it comes to identifying whether a property (or even a potato, for that matter) is being sold at a reasonable price. However, when it comes to stocks, people tend to take a simple way out and just look at the chart and buy it if it looks cheap compared to what it was before, assuming that the lower price should be reasonable and that it should eventually go back up. But there are plenty of stocks which do not do that, simply because at the core of a company’s share price is its earnings, and there are countless examples of companies whose earnings declined with time and did not recover. For local investors, just think of the one-time Temasek-owned blue-chip company Neptune Orient Lines Limited which once traded as high as $6 in 2007 but is about to be delisted at $1.30. In the worst-case scenario, a company can go out of business, and the investor loses all his money. Being able to estimate the fair value of a company’s share price will give you an idea of whether you should buy a stock, and as importantly when you should sell it. Methods to value a stock include calculating the value of the net assets a company owns, and/or estimating a company’s future cash flows and discounting them to the current value using a discount rate.
2. Manage Your Emotions
As Benjamin Graham, the father of value investing, puts it, “the investor’s chief problem – and even his worst enemy – is likely to be himself.” The ability to manage one’s emotions is arguably just as important as the ability to identify an undervalued stock. Many investors have trouble with this. Greed, fear and ego are three of the biggest factors that can cause an investor to make irrational investment decisions. When markets are exuberant, many investors tend to follow the crowd into the market since making money seems so easy, without taking any precautionary measures to manage the risks. By the time they do so, the markets are usually somewhere near the top. On the flip side, they are also usually the last ones to sell during a market crash due to the fear of taking losses and end up selling near the bottom. Resist the temptation to jump in and out of the market – those who stay invested in appropriately diversified portfolios enjoy better returns over the long term which is what counts.
3. Be Able To Calculate Your Investment Performance Accurately
Over the years I have met some investors who tell me that they have made a lot of money buying stocks. However, upon probing, I find that some of them have simply not accounted for their performance correctly. For example, some investors simply calculate the returns of the winners in their portfolio which they have sold. What about the losers? “Oh, I haven’t sold it yet, so it’s just a paper loss for now”, I’m told. Unfortunately, a paper loss is a real loss and needs to be counted as part of the portfolio’s performance. Sometimes, even when I tell them this, they usually shrug it off as if it isn’t really that important. Furthermore, because people tend not to sell their losers, and sell their winners too early, their investment portfolio’s performance is usually a lot worse than they realized because they did not take the paper losses into account. One bad investment can easily blow up the performance of an entire portfolio, especially in a portfolio which lacks diversification.
Another way investment performance is not measured properly is in accounting for the timing of the cash flows of the investments. For example, if you invested $10,000 on 19th January, added $5,000 on 25th March, took out $8,000 on 12th April, added another $10,000 on 7th August, what was your portfolio’s performance for the year on an annualized basis? If you cannot answer this question, then how would you know whether you have invested better than if you had simply put your money in a fixed deposit, or in a diversified portfolio of low-cost index funds? Again, most investors I have met have not accounted for their investments properly and therefore end up believing that they are much better stock pickers than they really are.
4. Be Willing And Able To Put In The Time
Estimating the fair value of stock prices takes time. To buy a company’s stock, you should be familiar with the company’s industry, the competition, the company’s management, business strategy, earnings, cash flows, and so on, so that you can reasonably come up with some projections about its future earnings and cash flows, and thereby estimate what the stock is worth. You should keep abreast of its financial health whenever it releases its earnings reports. And that’s just for one company. You would not want to put all your eggs into one basket because if that company goes belly up, you could lose everything. So you should ideally spread them out to at least ten to twenty different companies, if not hundreds or even thousands. Are you willing and able to put in the time required to keep tabs on the financial health and prospects of all these companies? If not, then perhaps you would be better off investing into either an active fund where a manager does all the monitoring for you or into a passive fund, where the index does the rebalancing of the securities for you.
Managing a stock portfolio is a lot harder than most people probably realise. Moreover, even if you are willing and able to do all of the above, your investment performance may not even necessarily be better than if you had invested in a diversified portfolio of low-cost index funds. Research has shown that most professional fund managers find it hard to beat the market consistently – and that is with all the superior resources that they have. In summary, if you have the interest and passion for managing a stock portfolio, and are willing to put in the time to be successful, by all means, do so. However, if you have neither the inclination nor the time, I believe you would be much better off investing into a diversified portfolio of low-cost index funds which would be more likely to give you better returns over the long term while being a lot less stressful and time-consuming.
This is an original article written by Sean Cheng, Solutions & Investments Executive at Providend, Singapore’s Fee-only Wealth Advisory Firm.
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