5 Ways to Become a Better Investor
Acting Wisely Is the Key to Long-Term Portfolio Success
Learning to manage your money and build an investment portfolio can be a difficult task for many new investors. For some people, it’s simply a matter of not having time to give proper attention to the way their wealth is invested and the risks to which they're exposing their hard-earned savings. For others, it comes down to a lack of interest in investing, finance, and money management. These folks might be smart, hardworking and even brilliant in other areas of life, but they prefer to do anything else rather than talk about numbers and figures — they don't want to dig through annual reports, Form 10-K filings, income statements, balance sheets, mutual fund prospectuses or proxy statements.
For a not-insignificant percentage of investors, it’s about temperament and emotional reaction. Despite their best intentions, they are, without a doubt, their own worst enemies, destroying wealth through sub-optimal decisions and reactions that are based on feeling rather than fact.
I believe certain things can help an investor better understand the purpose and nature of the capital allocation process. Although these tips can’t guarantee results, my hope is that by highlighting and discussing some common errors and overlooked mistakes, it will become easier for you to spot them in the real world.
Avoid Investing in Anything You Don’t Understand
People seem to forget this basic truth if they aren’t reminded. I prefer to distil it down into a handful of statements that can serve you well if you keep them in the back of your mind.
- You don’t have to invest in any one specific investment. Don’t let anyone convince you otherwise. It’s your money. You have not only the power to say now, but the right to do so, even if you can’t explain your reasoning.
- Plenty of opportunities will come along in life. Don’t let fear of missing out cause you to do foolish things.
- If you or the person managing your money can’t describe the underlying thesis of an investment — where and how the cash is generated, how much you're paying for that stream of cash, and how that cash will ultimately find its way back into your pocket — then you aren’t investing. You’re speculating. It may work out in your favor, but it’s a dangerous game that is best foregone or, at the very least, restricted to a small, isolated portion of your portfolio that does not involve the use of margin.
A tremendous amount of pain and suffering can be avoided when these basic three tenets are honored. Don’t dismiss them because they sound like common sense. As Voltaire succinctly and accurately observed, “Common sense is not so common.”
Understand That Market Value and Intrinsic Value Are Different
Imagine that you bought an office building in the Midwest, paying cash with no mortgage debt against the property. Your acquisition price was $1 million. The building is in a great location. The tenants are financially strong and locked into long-term leases that should ensure that rental checks keep flowing in for many years. You collect $100,000 a year in free cash flow from the building after covering things like taxes, maintenance and capital expenditure reserves.
The day after you buy the building, the banking industry collapses. Investors can’t get their hands on commercial mortgage loans and, as a result, property values become depressed. Over the subsequent year, buildings that sold for $1 million now go for only $600,000 because the only people who can afford to make acquisitions are cash buyers.
There's no doubt in this scenario that if you were to try to sell it, the likely market value of your property would be much less than the price you paid.
You might get $600,000 should you dump it on the open market. You might be able to get a much better price if you're able and willing to carry a privately-negotiated mortgage on which you effectively act as the bank for the buyer, who keeps diverting a portion of the rental income in the form of interest on the mortgage note to you after you’ve sold the building on which you now hold a lien. Nevertheless, if you were able to pull up quoted market values on your real estate investment, you’d be down in a very significant way on paper. It would be brutal.
For long-term investors, this is not particularly meaningful because true investors in the words of Benjamin Graham, the legendary father of value investing, true investors are rarely forced to sell their assets. Instead, they’ve run their finances conservatively enough that they can sit on depressed valuations for years at a time, knowing that they are still earning a good rate of return when measured as the cash flow that belongs to them relative to the price they paid for their ownership stake.
In this case, whether your building could fetch $600,000 or any other number at auction is not consequential compared to the fact you are collecting $100,000 in free cash flow from your ownership. That is the economic engine. That is the source of true or intrinsic value. Graham talked about the folly of becoming upset in a situation such as this because it amounted to allowing yourself to be emotionally distressed by other peoples’ mistakes in judgment. That is, you should not be looking to the market price to inform you of the intrinsic value of your property. You should know the intrinsic value of your property and be able to defend its calculation using conservatively-estimated, basic math. Think of the market price as something you can take advantage of if you so choose — nothing more, nothing less.
This concept remains true across multiple asset classes. If you have an ownership stake in a fantastic business with great returns on capital, a strong competitive position that makes it difficult to unseat in its given sector or industry, and a board of directors that is shareholder-friendly, it shouldn’t cause you any particular distress to watch your holdings decline by 50 percent or more on paper.
This is particularly true if it has a history of rewarding you with prudently-executed share repurchases and well-reasoned dividend increases, and you paid a reasonable price relative to the look-through earnings — or for more advanced investors who are familiar with accounting and finance, “owner earnings," a free cash flow adjustment calculated when evaluating operating companies, I know I repeat this frequently, but you should internalize it if you want to avoid destroying your wealth by foolishly selling high-quality, long-term assets because of what almost always turns out to be ephemeral fear.
Learn to Think in Terms of Net Present Value
A U.S. dollar isn’t just a U.S. dollar, and a Swiss franc isn’t just a Swiss franc. I’ve explained this concept over the years in several articles, including a few that are particularly germane:
- You’re Spending Your Millions $1 At A Time: A Lesson in the Time Value of Money
- Time Value of Money Formulas: How to Calculate the Future and Present Value of a Lump Sum
- To Beat Inflation, Focus on Purchasing Power Not Dollars: It’s What You Can Do With Your Money That Counts
From your perspective as an investor, it’s net present purchasing power that matters. Don’t fall into the trap of thinking in terms of nominal currency, a danger famed economist Irving Fisher described in his 1928 masterpiece, The Money Illusion.
If you have a $100 bill in your pocket today, the value of that $100 bill depends on a multitude of factors. If you have a long enough stretch of time and can earn satisfactory rates of return, compounding can work its magic and turn it into $10,000. If you haven’t eaten in two days, the utility of future money is practically non-existent compared to the opportunity to use that money now. Successful investing is about making choices. Frame your spending and investing decisions this way. Money is a tool — that’s all. Remembering this can help you avoid the mistake that many men, women and families make, sacrificing their true long-term desires for their short-term wants.
Pay Attention to Taxes, Costs and Terms
Small things matter, particularly over time due to the forces of compounding that we’ve discussed. There are all sorts of strategies you can use to keep more of your hard-earned money in your pocket, including things like asset placement. Think of a fixed-income investor holding tax-free municipal bonds in taxable brokerage accounts and corporate bonds in tax shelters such as a Roth IRA. He knows how to take advantage of what amounts to positive leveraging effects, such as capturing the free money you get when your employer matches contributions to your 401(k) or 403(b) retirement plan. It's worth your time and effort to discover them. With only tiny tweaks, particularly early on in the compounding process, you have an opportunity to change your potential payouts meaningfully. Few things in life are so worth your time.
Make sure you're weighing the value of what you're receiving against the costs. I’ve seen a lot of inexperienced investors focusing on things like expense ratios and management costs to the exclusion of everything else. They ultimately cost themselves far more in things like dumb tax mistakes or painful risk exposures that cause their accounts to implode.
An example I like to use is the management of trust funds. Take Vanguard, for example. At the time I wrote this article, Vanguard’s trust department would run what amounted to a very simple trust fund for $500,000 — nothing complex, just plain vanilla. You wouldn't get individual securities but you would instead own the same mutual funds everyone else owns. There’s not a lot of planning flexibility for what, — depending upon the selections made in the asset allocation process — amounts to an all-in effective look-through fee of between 1.5 and 1.6 percent per annum by the time you calculate things like trustee fees and underlying management fees.
That’s a fantastic deal for what you’re getting. I’ve watched people blow six- and seven-figure inheritances faster than you can blink, all of which could have been avoided had the money been locked in trust and the grantor been willing to pay the fees. In other words, the grantor paid more attention to something that didn’t matter — namely trying to pay 0.05 percent in fees per year by doing it himself rather than 1.5 to 1.6 percent by outsourcing it to someone else. Compare that to a much more relevant factor: the emotional stability and financial prowess of the beneficiary. This stuff matters. Your investment portfolio does not exist in a textbook. The real world is messy and people are complicated.
Never Think About Performance Alone Without Factoring in Risk Exposure
Like many entrepreneurs, I think about risk a lot. My temperament is a strange mix of constant probability calculations mixed with optimism. When my husband and I launched our letterman jacket awards company more than a decade ago, we carefully designed the cost structure in a way that we won under almost any scenario. When launched our global asset management company for affluent and high net worth individuals, families and institutions that wanted to invest alongside us, we made sure our initial Form ADV disclosures contained discussions about some of the risks.
It’s an incredibly dangerous sign when investors start talking about their “great” returns without discussing how those returns were generated. The risk exposure to which you exposed your capital, measured not by volatility in market quotation but in the price paid relative to intrinsic value with an adjustment for the potential of wipeout, is the real secret of building wealth over the long term. One of history’s most famous investors is fond of pointing out that it doesn’t matter how great returns are — if there is a single “zero” in the multiplication, you lose everything. This holds true not only in the investment management of your portfolio, but in the operating management of entire companies. The implosion of AIG, formerly one of the world’s strongest financial institutions and most respected blue chip stocks, is a perfect case study that every serious investor should undertake.
Personally, I’m of the opinion that this can be distilled into the following guidelines:
- Pay for your investments, in full and with cash.
- Only buy stocks or bonds that you’d be happy to own for the next five years if the stock market closed and you couldn’t get a quoted market valuation on it.
- Avoid securities issued in certain sectors, industries or lines of business, particularly if they are further down the capital structure. For example, absent some extraordinarily rare circumstances, a lot of value investors are generally not interested in the common stock of an airline at any price unless it serves as a small speculative augment to a broader, more diversified portfolio. They think the valuation justifies it. Even then, they’d still likely walk away from the opportunity. The reason? On the whole, airlines have what amounts to a constant, could-be-triggered-at-any-time bankruptcy risk. It's a business that sees revenue levels plummet in the event of war, catastrophe or general economic conditions. Couple that with the high operating cost structure and commodity pricing, and, with one major exception, it has been financially ruinous for long-term owners.
This requires looking at your portfolio differently. Your portfolio should not be a source of excitement or emotional thrills the same way walking onto the floor of a casino in Las Vegas is for a lot of people. Successful investing often resembles watching paint dry. You find great assets, pay reasonable prices for them, then you sit on your behind for a few decades while capitalism and compounding shower you with the rewards. Throw in some diversification so the inevitable bankruptcy or impairment of one or more components along the way doesn’t harm you too badly. Historically, it’s been a dream combination. While it’s true that history may not repeat itself, for those who understand the odds, it’s not hard to argue that it’s probably the only intelligent way to behave.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.