What works in investing? I don’t mean that question the obvious way-that it’s a place where people buy and sell stocks through brokers. What I mean is how you think stock prices are really set. What is your mental model of how prices are decided?

A flawed mental model can lead to some interesting conclusions. For example, in the early days of email, a friend of a mine believed that if you reduced the font size in an email message, then the message would become smaller and therefore easier to send. It was a flawed mental model, or rather, was the fax mental model being applied to email.

I believe one of the fundamental reasons why so many people have trouble investing in the stock markets is that they have severely flawed mental models of what determines a stock price. While there are many mental models of how the stock markets work, some are more common than others.

This is the most widespread one: ‘There are people who know when a stock’s price is about to rise. If one of them tells me, then I can make money.’ This is the ‘tip’ model of the stock markets. It isn’t so much a mental model as the lack of one. Unfortunately, this is a very common one. There seem to be a lot of people who believe that someone out there knows which way things will move and everything depends on somehow getting to know these secrets.

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A little broader than the ‘tip’ model is the ‘operator’ model. Under the operator model, people believe that there are people (“operators”) who manipulate stocks and what one needs is to figure out what the operators are doing and then somehow, manage to ride the stock while the operator is pushing it. This model is actually realistic. Outside the big, high volume tickers, many, many stocks are routinely manipulated by the so-called ‘operators’, at least in the short-term.

However, this model is useful only for the operators themselves. To succeed, operators need greater and greater fools to buy into the stock they are operating on. Basically, if you are not an operator yourself, you are under considerable risk of giving away your money to an operator. For a surprisingly large number of people-many of them regular investors-the markets are primarily driven by conspiracy. There are secret cabals of operators who decide practically everything and then they just make it happen.

There is, of course, yet another model. This one is about researching companies, figuring out their businesses, projecting what could possibly happen in the future and then deciding which stocks to buy, which not to buy and when to sell the ones you have bought. However, compared to the ‘tip’ model and the ‘operator’ model, such a small number of people believe in it that perhaps it’s just a fringe idea. What do you think?

This is a fairly long read, most of you will leave before you reach halfway and say “I know the ropes, I know the game and I know the rules, what the heck is this guy talking about?” If you think this is a load of crap and you are a master, get off my site and go invest all your money, I know jolly well that you know nothing. Oh yeah! before you go make sure to bookmark this page, you will need to read it when the damage is done. Ask 8 out of 10 people why they invested in a particular stock, the answers will be like “Its a great stock and besides most of my friends have invested too.” The truth is they don’t have a clue. If you do happen to read till the end, I’d love to hear from you.  Assuming I have your attention and interest, please read on.

It is important to be independent in our decisions to invest, and be able to evaluate and understand the companies that we are considering for potential investment. In this article, I want to share with you some of the things that I look at when deciding if a stock is a good investment or not.

Revenue
To pick out a stock that will create good long-term value for its shareholders, investors need to look at the sales figure to see if it is growing at a healthy rate long-term.

Investors should, however, make sure that the company is not over-aggressive in its expansion and taking on too much debt; spreading itself too thin. Investors should also make sure that the company is not in the habit of regularly issuing new stock to fund its growth, as this kind of activities will dilute the holdings of shareholders. The best companies are usually the ones that can mostly or fully fund their expansion from internally generated funds.

Investors also shouldn’t overpay for stocks with high growth rates, as this will put investors in a situation where they find themselves with big losses because a high-growth company they bought shares in missed earnings estimates by 0.1% or something.

It is important to figure out if the growth rate of the company is sustainable by reading the annual report for information on growth and looking at the industry the company is in, as well as the size of the company in relation to the size of its largest competitors. A company doing $8 billion dollars in sales in a mature industry where its biggest competitor is only doing $10 billion dollars in sales generally can’t grow much and shouldn’t have too high a rate of growth.
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Most important, however, is that an increase in sales is only a good thing if there is an equivalent growth rate or a higher growth rate (due to scale) in income over the long-term. We will look into income a little later in this article.

While I do believe that investors can get good profits from investing in large-cap stocks, I also believe that if investors are looking for stocks that have the potential to go up 20-30 times in value that they have to look for this kind of gains in small-cap to medium-cap stocks. It’s much easier for a $20 million dollar company to grow ten times its size than it is for a $100 billion dollar company to even double its size.

Operating Income
Investors should look for companies with operating incomes that are rising. There don’t have to be an increase in income every quarter or even every year, but there should be healthy growth in profits over the long-term.

The operating margin is the percentage of revenue a company translates to profit before paying interest and taxes, and before taking into account non-operating profits and losses. A company earning higher margins is able to expand faster and better fund its expansion from funds generated internally, while relying less on debt or issuing new shares that will dilute the holdings of its shareholders.

Many companies make losses during recessions as demand for their products drop. Companies with high operating margins are, to a certain extent, somewhat protected from adverse economic conditions and may still make at least some money during bad times. Additionally, when there is an increase in the costs of materials, companies with higher margins are able to delay passing on the increased costs to the customer and gain market share from their competitors that have no choice but to raise prices early.

While it’s true that investors should generally look for companies with high profit margins, in industries with high profit margins, investors should also take into account things like business models, return on equity, and expansion plans. Wal-Mart for example thrives on a business model that entails low margins, because it is its business model that permits it to earn a high rate of return on equity and experience great growth that turned it into the largest retailer in the world. All this has translated to very impressive profits for shareholders over the long-term.

Companies spending aggressively on expansion will temporarily experience lower profit margins (It is important that each dollar a company retains to expand its business, returns to shareholders in the future as more than a dollar plus whatever return shareholders could acceptably have earned had the company instead paid out dividends with the money used for expansion).

Net Income
While operating income allows us to have a better idea of the efficiency and growth of the company, net income is a more accurate measure of the current profitability of a company, as net income takes into account taxes and interest expense.

The Price/Earnings ratio can help investors tell if a stock is cheap. Generally, a low P/E ratio indicates that the stock is cheap. Investors should, however, take into account that a low P/E ratio could also be a sign of bad things to come. The P/E ratio could also be low because of big one-time gains (which should be taken out when evaluating profits). Companies can manipulate earnings, or accounting rules can give temporary boosts to earnings, and these things will also result in the P/E ratio being unreliable.

Investors should add the latest annual net income figure available with net income figures from the past few years and average them out. This will somewhat give investors a more normalized view of profits. The same goes for operating income and return on equity.

Return on Equity
It isn’t difficult for companies to increase earnings. Companies can for example, take on more debt or retain earnings to deploy in profit generating projects. What’s important is the return on equity, as that is the rate of return earned on shareholders’ money.

Here are some questions investors need to ask themselves with regard to return on equity: “Does the increase in assets and liabilities due to the company taking on more debt translate to an increase in return on equity that’s significant enough to compensate shareholders for the increased risks inherent in holding stock in a company that has become more leveraged?”

“Can the company continue to achieve an above average return on its equity that’s constantly rising (due to retained earnings)?”

Investors should always look for companies with high returns on equity (and if possible, rising return on equity), but should also beware of companies earning high returns on equity solely due to the fact that they are taking on lots of debt and operating on very low levels of equity in comparison to their assets.

When analyzing stocks, it is important to see if the return on equity is consistent over the long-term, even if equity has been gradually rising over the years. If the amount of debt has been rising over the years, investors need to make sure that the increase in assets paid for with money the company borrowed resulted in an increase in return on equity that is acceptable.

These are some other things that investors can factor in when evaluating a company’s return on equity:

As an organization grows bigger, it might not be able to sustain its growth without adding new products to their product line, expanding into different lines of business, or entering new markets. The company’s expanded operations might not be able to generate a return on equity that’s similar to that of its past operations (This assumes that the company uses mostly retained earnings and little or no debt to fund its growth). In this kind of situations, investors need to ensure that if the company is not able to achieve a return on equity that is as high as the past, the company has to at least achieve a return on equity that’s above average.

Increased competition is another factor that can reduce a company’s profits and ultimately the company’s return on equity.

Balance Sheet Strength
Investors should generally look for companies with as little debt as possible and as much cash as possible. I usually look for companies with cash and short term investments equaling at least 40% of total liabilities and 150% of current liabilities.

For me the more cash the company has the better, as cash allows a company to weather downturns and even take opportunities during downturns to acquire assets at depressed prices. While on the surface I think it is a good thing for a company to have lots of excess cash, I also would need the company to have a great track record in terms of using its cash wisely, whether it has been known to make great acquisitions at reasonable prices, launching share buyback programs when the company’s stock is undervalued, or etc.

Companies shouldn’t have excess cash for a long period of time as not only will inflation erode the value of the company’s cash holdings, but the shareholders will be much better off if the company paid out its excess cash in dividends.

I can’t remember the exact quote, but Warren Buffett once said something along the lines of “If you’re smart you don’t need debt, and if you’re dumb you shouldn’t get involved with debt in the first place.” I try to recall this quote every time I think about personally taking on debt to invest or buying stock in a company that have a little bit too much debt for my liking.

I generally dislike debt, but I do understand that companies can benefit from taking on debt when the cost of debt is very low. However, I find it important that the company don’t take on more debt than it can very comfortably manage, no matter how low the company’s cost of debt is. When evaluating if a company has taken on too much debt, I generally look at book value to total liabilities, cash to total liabilities, and owner earnings to total liabilities.

Another thing I look at when investing in a company that has debt is the maturities of the company’s debts in the short to medium term, and if the company is able to build up enough cash to repay any maturing debt in the near to medium term. I also look at the company’s cost of debt and will tend to exclude the stock from my list of potential investments if the cost of debt is too high, as not only will it be harder for the company to service its debt, but it is a sign that there could be something fundamentally wrong with the company that justifies it having to pay higher interest rates on its debts.

This segment of the article describes very generally some of the things I look at when evaluating companies’ balance sheets. There are of course other things that investors should take into consideration when evaluating a balance sheet.

Owner earnings
Warren Buffett wrote about a concept he called “owner earnings” in Berkshire’s 1986 letter to shareholders. While it has been quite some time since I read about owner earnings, this is how I calculate owner’s earnings:

Net profit (I try and take out one-time gains or losses) + depreciation and amortization +/- certain non-cash items – average capital expenditure needed to maintain current profitability and competitive advantage – increase in working capital (if there is).

Some companies might be building up cash, and this might result in a significant increase in working capital. I try to take this into account by factoring out the cash portion of the working capital increase once the company’s total cash reaches a certain percentage of current liabilities(depending on the industry the company is in and what you believe is enough cash for the company to run smoothly).

After calculating the owner earnings figure, I will discount the company’s owner earnings for the next 20 years (I use 20 years as I feel that this is the minimum timeframe for long-term investing, investors can of course use their own timeframes) to the present at a discount rate of 6-7%. I suggest applying a 6-7% discount rate, as I feel these are the returns investors can very reasonably earn over the long-term by dollar cost averaging into a low-cost index fund. The value I get from discounting all the owner earnings to the present will be the base from which I will determine the company’s intrinsic value.

After I’m confident that I’ve roughly arrived at the intrinsic value of the company, and I believe that the stock of the company will make a good investment, I make sure that there’s a margin of safety before buying the stock. I generally look for the market price of the stock to be at least 40% below my estimate of the stock’s intrinsic value but may require less of a margin depending on factors like high profit margins, strong cash position, and etc. No matter how sure an investor is in his or her calculation of the intrinsic value of a stock, the investor, to be prudent, should still have a significant margin of safety when investing, as this will give the investor some protection if things at the company don’t go well, if there are adverse economic conditions in the future, if the investor’s valuation of the company is off, and etc.

Investors should note that different people may come up with a different value for owner earnings, as well as a different intrinsic value for the same company.

(I read a little bit about the margin of safety before, and I know that Benjamin Graham wrote about it in the “Intelligent Investor” (which for some dumb reason I haven’t read), but I currently don’t have a good understanding about the margin of safety, and I’m not sure if I’m applying the concept correctly (even though I think what I’m doing makes sense). I am of course going to make reading the “Intelligent Investor” a top priority, but until then, I would greatly appreciate it if anyone could share some information about the margin of safety).

Competitive advantage
Companies need to have some sort of a competitive advantage if they are to produce good returns for shareholders over the long-term. A great brand or a great reputation, an effective distribution system, an exceptionally strong focus on the customer, being the low-cost producer, having a product that’s the de facto standard, and having a great business model that is incredibly difficult to profitably copy can all be a source of competitive advantage.

Economies of scale can be said to be a source of competitive advantage, but I wouldn’t, in most cases, count on it being a lasting competitive advantage over the long-term as some competitors can gain scale with time. There are also an increasing number of smaller companies that are able to effectively compete against their larger counterparts due to the fact that they are able to successfully integrate technology into their business models. Don’t get me wrong, economies of scale is great and can contribute to a company being a low-cost producer, I just don’t think it’s a very substantial competitive advantage on its own.

I do, however, believe that having a near monopoly over a market is an excellent source of competitive advantage. Companies that have achieved almost monopoly status not only get all the possible advantages of scale in their markets, but also pricing power as a result of their huge market share, as well as significantly higher margins than they normally would due to a lack of meaningful competition which would most certainly put pressure on prices.

Usually, there is a reason why some companies are able reach a point where they’re almost monopolizing their respective markets. The reason could for example be a license that makes the company the sole distributor of a certain product, or the company has a product or line of products that have become the de facto standard in their product category (example: Windows engine). These reasons are the things that make these companies able to somewhat sustain their near monopolies over their markets.

Intellectual property, especially in industries like the pharmaceutical industry, can be a great source of competitive advantage assuming that the company has a great R&D department that works closely with the production and marketing departments to consistently come up with feasible and profitable products that have a big enough market potential for the company to enjoy really huge returns (needed to compensate for the risk that the new products won’t be successful) on R&D costs and the costs needed to bring the new products to market.

There are also competitive advantages that are unique to their industries. In the banking industry for example, a large cheap deposits base is a source of competitive advantage.

Great management is also a very good source of competitive advantage. Here are a few things to look for to tell if management is good:

Management is committed to enhancing long-term shareholder value. Management that aims to enhance shareholder value will do things like buyback shares when the stock is undervalued, pay out dividends when the company can no longer reinvest earnings at higher returns than shareholders can, and focus on activities that will result in long-term profits.

Management has a good track record of doing what they say, whether it is to cut costs, reduce debt, increase revenue contribution from a certain division, or etc.

Management is committed to keeping costs low. This can be seen in terms of the company’s selling/general/administrative expenses being significant lower than that of similar size competitors.

Management is conservative. A company that is run by conservative management will have low debt levels and hold enough cash on its balance sheet to ensure that the company doesn’t find itself in financial trouble. The company will also distance itself from risky activities.

The executives own shares in the company worth significantly more than their total annual compensation. The shares these executives own should come not only from stock options, but also from them investing their own money on their own account. While this doesn’t indicate that management is good, it ensures investors that management’s interests are aligned with the shareholders.

Management should be honest and open with shareholders, whether it’s about the current performance of the company, the company’s goals and the progress made towards those goals, the slip ups of the company, or etc.

Price & Understanding your investments
Companies in different industries are valued differently. For example: book value and cost of funds are important in determining the value of a bank, while a lot of weight is put on same-store sales figures in the evaluation of the investment appeal of retailers.

Not knowing what to look for in a particular industry, can lead to investors not being able to properly value companies in that industry. Because of this, investors should put their efforts into analyzing stocks in industries they understand, as this will increase their chances of properly identifying and valuing a truly great company. It is also important to note that great companies can be found over many different industries, and investors will be better off specializing in and really understanding a few industries (even one will do) as opposed to knowing just a bit about many different industries.

Investors should always try to avoid overpaying for stocks, and should instead just build up cash and wait for the stocks they like to become undervalued. This is one of the most basic rules in investment, and everyone knows this, but there will always be people who will still do it anyway, whether they realize it or not. A 50% loss on overpaying for a “hot stock” that has come back to ground will require the stock to go up by a 100% (which could be years) from its no longer irrational price just for you to breakeven. So, even if you are confident that you’ve found a really great stock, you should wait till the price of the stock drop to a point where if bought, could turn out to be a very great investment.

Most people enter the investment arena thinking that “Risk” is a board game they played in college. Today, I would guess that the majority of investors have never owned an individual share of common stock or a Municipal Bond.

The popularity of investment products has heightened the risk for all investors and has indirectly led to many of the policy errors that threaten both capitalism and the economic fabric of America. Market prices are increasingly and inappropriately influenced by decision-making based only on the derivatives that contain them.

Few people consider the investment risk associated with public policy decisions. Product investors and derivative speculators participate in less personal markets, where it is more difficult to connect the dots between their personal financial interests and their political alignments.

So in a very real sense, investors have to deal with public policy risk every bit as much as they need to analyze the risks associated with the securities and other financial products they hold in their portfolios — complicated, but it is doable.

Apart from these important peripheral considerations, the risk of loss in any equity investment is generally greater than the risk of loss in any debt related instrument. The potential reward from each type is just the opposite, and that’s where all the excitement begins.

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Do we risk more for the chance of a greater return, or do we risk less and try to preserve our investment capital? Keeping in mind that investment capital is a measure of cost, not of market value, and that the only real loss is a realized loss.

Typically, the older the investor, the more boring or income focused the portfolio should be — minimizing the overall level of risk. But it’s difficult to actively minimize or manage your risk in the “open end” mutual fund or passively managed ETF marketplaces.

Risk minimization requires the identification of what’s inside a portfolio. Risk control requires decision-making by the owner of the investment assets. Risk management requires a selection process from a universe of securities that meet a known set of qualitative standards.

Product owners assume the added “fear and greed” risk of the general population, while their fund mangers stand aside and mumble about the opportunities lost in either direction.

Without a risk sensitive menu to select from, 401(k) participants need to minimize risk by: (a) avoiding the poor diversification that may be a requirement of their plan, and (b) developing outside income portfolios with any invest-able income above the employer matching contribution.

The first and most important management action focused on risk minimization in any “program” is the development of an asset allocation plan. The plan separates “liquid” investment assets into two buckets (Equity and Income) based on cost, not market value. No portfolio should have less than 30% in the income bucket — no ifs, ands, or buts.

And no investment plan should be developed “tax” or “cost” first. Risk minimization comes first, and then tax minimization if possible. Finally, transaction cost minimization can be considered if you are qualified to run your program yourself.

A cost based asset allocation approach (Working Capital Model) assures growing levels of “base income” throughout the portfolio development process and, possibly, into retirement. Income growth, by the way, is the only real hedge against that other economic risk, inflation — a buying power problem that has nothing to do with the market value of the income producing assets.

Minimizing investment risk is done best through the use of disciplined sets of rules for the various operations involved in managing a portfolio. Strict rules need to be developed for security selection, three types of diversification, income production, and for profit taking.

Forget the Wall Street “I-can-fix-that” product menagerie. We’re not interested in massaging our market value to take the sting out of cyclical market value changes. Our plan is to take advantage of these changes as they unwind around us over time, and when they occur unexpectedly, causing short-term disruptions and dislocations.

In the securities markets (stocks and bonds), the real risk of loss can be minimized without products and futures speculations, without commodities and hedge funds, and without the ageda that most people experience throughout their investment lifetimes.

The old fashioned principles of investing: Quality, Diversification, and Income, plus disciplined, targeted, Profit Taking are the only hedges an investment portfolio needs to assure long-term success. Conveniently, the QDI+PT applies equally well to both classes of investment securities.

“Q” is for quality. If you study the long-term behavior of Investment Grade Value Stocks, and high quality income CEFs, you’ll discover that they hedge themselves quite effectively.

Risk is wrung out of portfolios by investing only in S & P, B+ or better rated, dividend paying, and historically profitable companies and then only when their equity prices are well below their 52-week highs.

“D” is for diversification. Absolutely never allow any position in your portfolio to exceed 5% of total portfolio working capital (i.e., the total cost basis) and never start a position anywhere near maximum exposure. You want to be able to buy more at lower prices.

Similar diversification rules apply to industry exposure and global diversification through the use of the mainly world class companies in the investment grade quality categories.

“I” is for income. Own no security that does not pay regular, dependable, dividends or interest. Regular and growing dividends are a quality indicator in equities. In the income “bucket”, seek out above average yields while avoiding those that seem either too high or two low.

Managed closed end funds do it best and provide easy “PT” and “buy more” opportunities. Buy established CEFs with long term “income” (not ROC) payment records.

“PT” is for profit taking. Absolutely always smile and take your profits willingly, net/net 7% to 10% (dependent upon available reinvestment possibilities and security class), and never, ever, look back.

Trading this same body of securities, again and again, has been shown to sustain growth of capital and income consistently in a relatively low risk environment.

“October is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February.” Mark Twain

Image Courtsey
“You should always live within your income, even if you have to borrow to do so.” J Billings.

“I have enough money to last me the rest of my life, unless I buy something.” – Jackie Mason

“The financial markets generally are unpredictable. So that one has to have different scenarios.. The idea that you can actually predict what’s going to happen contradicts my way of looking at the market.” – GeorgeSoros.

“When buying shares, ask yourself, would you buy the whole company?” – Rene Rivki.

“I made my money the old fashioned way. I was very nice to a wealthy relative right before he died.” – Malcolm Forbes

“I‘m so naive about finances. Once when my mother mentioned an amount and I realized I didn’t understand, she had to explain: ‘That’s like three Mercedes.’ Then I understood”. – Brooke Shields

“There’s no reason to be the richest man in the cemetery. You can’t do any business from there”. – Colonel Sanders

A man explained inflation to his wife thus: “When we married, you measured 36-24-36. Now you’re 42-42-42. There’s more of you, but you are not worth as much.” – Lord Barnett.

Every morning I get up and look through the Forbes list of the richest people in America. If I’m not there, I go to work. – Robert Orben.

Anyone who lives within their means suffers from a lack of imagination. – Oscar Wilde

Boaters run aground by not paying attention to tides, charts, navigation tools and their GPSes. Investors get swamped with information, media noise, breaking news, politicians, gurus, and derivatives — so much so that they can’t see the oncoming fog banks and tsunamis of cyclical change.

Most investment mistakes are caused by basic misunderstandings of the securities markets and by invalid performance expectations. Losing money on an investment may not be the result of an investment sandbar and not all mistakes in judgment result in broken propellers.

Errors occur most frequently when judgment is rocked out of the boat by emotion, hindsight, and misconceptions about how securities react to waves of varying economic, political, and hysterical circumstances. You are the commander of your investment fleet. Use these ten risk-minimizers as lifeboats:

1. Identify realistic goals that include time, risk-tolerance, and future income requirements — chart your course before you leave the pier. A well thought out plan will minimize tacking maneuvers. A well-captained plan will not need trendy hardware or exotic rigging.

2. Learn to distinguish between asset allocation and diversification. Asset allocation divides the portfolio between equity and income securities. Diversification limits the size of individual holdings in several ways. Both hedge against the risk of loss. Both are done best using a cost based approach.

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3. Be patient with your plan and think of it as a long-term voyage to a specific destination — change direction infrequently and gradually. There is no popular index or average that matches your portfolio, and calendar sub-divisions have no relationship to market, interest rate, or economic cycles.

4. Never fall in love with a security. No reasonable profit, in either class of security, should ever go unrealized. Profit targeting must be part of your plan, and keep in mind that three sevens beats two tens — and is much easier to achieve.

5. Prevent “analysis paralysis” from short-circuiting your decision-making powers. Limit the information you allow into your course charting process, and avoid any form of future prediction or bet covering.

6. Burn, delete, toss-out-the-window any short cuts or gimmicks that are supposed to provide instant stock picking success with minimum effort. Consumers’ obsession with products underlines how Wall Street has made it impossible for financial professionals to survive without them. Remember: consumers buy products; investors select securities.

7. Attend a workshop on interest rate expectation (IRE) sensitive securities and learn to deal with changes in their market value — in either direction. Few investors ever realize the full power of their income portfolio. Market value changes must be expected and understood, not reacted to with fear or greed. Fixed income does not mean fixed price.

8. Ignore Mother Nature’s evil twin daughters, speculation and pessimism. They’ll con you into buying at market peaks and panicking when prices fall, ignoring the cyclical opportunities provided by their Momma. Never buy at all time high prices and avoid story stocks religiously. Always buy slowly when prices fall and sell quickly when targets are reached.

9. Step away from calendar year, market value thinking. Most investment errors involve unrealistic time horizon, and/or “apples to oranges” performance comparisons. The get rich slowly path is a more reliable investment road that Wall Street has allowed to become overgrown, if not abandoned.

10. Avoid the cheap, the easy, the confusing, the most popular, the future knowing, and the one-size-fits-all. There are no freebies or sure things on Wall Street, and the further you stray from conventional stocks and bonds, the more risk you are adding to your portfolio.

Compounding the problems that investors face managing their investments is the sensationalism that the media brings to the process. Investing is a personal project where individual/family goals and objectives must dictate portfolio structure, management strategy, and performance evaluation techniques. It is not a competitive event.

Do most individual investors have difficulty minimizing investment risk in an environment that encourages instant gratification, supports all forms of speculation, and gets off on shortsighted reports, reactions, and achievements?

You bet they do!

Weekend Humor

Most investors incorrectly think of “risk” as the possibility that the market value of a financial asset might fall below the amount that he or she has invested in the asset. OMG, how could this be happening!

Think about it. The harboring of these misconceptions (that lower market price = loss or bad and/or that higher market price = profit or good) is the greatest risk creator of all. It invariably causes inappropriate actions within the large mass of individuals who are uninitiated in the ways of the investment gods.

Risk is the reality of financial assets and financial markets: the current value of all securities will change, from “real” property through time-restrained futures speculations. Anything that is “marketable” is subject to changes in market value. It is as the gods intended, and portfolios can be designed so that it just doesn’t matter quite so much as you’ve been brainwashed into thinking.

What is abnormal is the hype surrounding market value changes and the hysteria such hype causes among investors. No way should a weak real estate market translate into near zero bank balance sheet entries — it just doesn’t compute, except when it is popular politics.
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Similarly, the reality of financial-impact cycles (market, interest rate, economy, industry, etc.) just doesn’t fit at all into the hindsightful, but popular and generally accepted, calendar year assessment mechanisms. Brainwashing again.

The amount, cause, frequency, range, and duration of market value change will always vary in an “I-don’t-care-who-you-listen-to” unpredictably certain way — the certainty being that the change in market values of investment assets is inevitable, unpredictable, and essential to long term investment success.

Without these natural changes, there would be no hope of gain, no chance of buying low and selling higher. No risk, no profits, and no excitement— boring!

The first steps in risk minimization are cerebral, and involve developing an understanding of the fundamental economic purpose of the two basic classes of investment securities.

From the investors’ perspective: (a) equity securities are expected to produce growth in the form of realized capital gains, and (b) income securities are expected to produce spendable (or reinvestable) income. But it isn’t real growth until it’s realized, or real income until it’s received.

Alternative investments? These are the contracts, gimmicks, commodities, hedges, and other creative ideas that college textbooks used to call speculations. Once upon a time, fiduciaries, trustees, and unsophisticated individuals weren’t allowed to use them. The stigma is gone, but the artificial demand adds risk to all markets.

They are especially risky for the millions of 401(k) and IRA investors who probably cannot explain the difference between stocks and bonds, from any perspective. Most investors have virtually no clue what is actually being done inside the products they select, and have even less of an interest in learning about it. They dance knee-jerk style to the daily media buzz.

Wall Street knows this, and takes advantage of it mercilessly. In spite of the recent financial crisis, pension plan fiduciaries (particularly in the public sector, go figure) are falling all over themselves to throw money at the very alternative and derivative speculations that crashed the market just months ago.

401(k) participants are force fed products du jour from self-serving providor menus that make little effort to identify risk, much less minimize it. Very few plans allow participants to develop an understanding of their investment choices with the only education provided by the product vendors themselves.

What ever happened to stocks and bonds, the building blocks of capitalism? Do investors recognize the financial interest they have in the very corporations their elected officials are encouraged to tax, constrain, and regulate into competitive mediocrity?

Another mental step in risk minimization is education. You just can’t afford to put money into things you don’t understand, or which the salesman can’t explain to you in ordinary English, Spanish, French, whatever.

Of course you would prefer to skip this step and jump right into some new product athletic shoes that will hurdle you over the work and directly into the profits. How’s that been working out for you? It was once written (somewhere): no work, no reward.

Risk is compounded by ignorance, multiplied by gimmickry, and exacerbated by emotion. It is halved with education, ameliorated with cost-based asset allocation, and managed with disciplined: selection quality, diversification, and income rules— The QDI.

Real financial risk in equities boils down to: the possibility that a company’s stock (that 30% share of your brother-in-laws’ pizza parlor) will become worthless as management succumbs to economic forces, and/or mandated costs imposed by outside entities whose edicts must be complied with.

In debt-based securities, risk is: the possibility that the issuer of an interest bearing IOU (the money your spouse loaned her brother at 6% to start flinging pizza) stops or falls behind on its payment obligations and/or declares bankruptcy and wipes out both owner (shareholder) and creditor (bond holder) interests.

Here’s an interesting risk in the securities markets, one that governments have cleverly refused to address for fairly obvious reasons. The “Masters of the Universe” routinely get paid obscene amounts of compensation for risking OPM (other people’s money) perhaps a bit too cavalierly.

Company fails, shareholder interests become valueless, debt obligations are worthless, while the fat cats keep raking it in, even suing to preserve their bonuses. Boardroom corruption, and direct lobbying (another euphemism, for bribing) of elected officials are two additional risks that investors need to be aware of.

Steve Selengut

Can be contacted on steves AT sancoservices DOT com

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