Beginners guide to investing part 4:How to approach the sharemarket

“Theories that are right only 50% of the time are less economical than coin flipping

— George J Stigler

1/. FUNDAMENTAL ANALYSIS

Fundamental analysts argue that each investment has an intrinsic value. They believe in researching companies and their performance. They believe that all shares that are above or below value will return to market value rapidly due to investors noticing these imperfections and making the correction by buying and selling.

The fundamentalist generally uses 4 determinants to determine the proper value of a stock. The expected growth rate (and for how long), the expected dividends, the degree of risk, and the level of market interest rates (such as for savings or bonds).

The advantages of using fundamental analysis are:

  • Focuses on the value of the stock only. You are ignoring all the other ‘noise’ that may be distracting from the true value.
  • Not using emotions to make decisions

The problems with fundamental analysis are:

  • It is impossible to make future predictions about the price movements of stocks. Future events, such as earthquakes, change in government legislation can’t be predicted.
  • The best advisers/researchers often end up getting promoted leaving your fund with a new adviser. Advisers can and do make mistakes in their calculations.
  • Investors are making decisions based on company data and financial statements. How can we be certain these are accurate? Companies have been known to fudge their books to make their company appear more attractive to investors.
  • Takes a lot of time and research.
  • People do use emotions when buying and selling stocks, and these are impossible to predict. 

 

2/. TECHNICAL ANALYSIS

Technical analysts believe that markets depend on the behaviours of the individuals in the market. Common traits of humans are to be overconfident and to follow the herd. This may help explain why we have speculative bubbles. As the price of stocks go up, people get more confident and people start investing more and more people start investing.

During bull (rising) markets the ‘greater fools theory’ may apply where people keep buying at higher and higher prices believing that someone else will always buy off them from a higher price. Parallels can be drawn to the ‘heated’ Auckland housing market or Bitcoin mania in late 2017. There will come a point when there are no more ‘fools’ willing to buy. This is the point that the market peaks.

The advantages of using technical analysis are:

  • By understanding the psychology or trends of investing, one may be more able to recognise over or undervalued markets, and make good value investing decisions based on other people’s behavioural biases.

The problems with technical analysis are:

  • There is a lot of guess work. How do we know for sure if the overconfidence in the market is warranted or not?

 

FUNDAMENTAL VS TECHNICAL

A fundamental analyst argues that behavioural biases and the irrational behaviour of investors is only short-term, until the market quickly corrects itself. Believers in behavioural (technical) finance believe that this is simply not true. They say the irrational behaviour of investors is not a one-off event, but happens continuously.

Both methods of investing require predictions and guess work and can be seen as gambling by some. Trying to time the market is not for everyone due to the high levels of risk. They believe they can arbitrage specific shares so that they sell the high valued stock and buy the low valued stock, but this entails plenty of risk. I.e. The stock they thought was low value may continue to go down and the highly valued stock may continue to go up. The fundamental or technical investor may miss out on the best days in the sharemarket because they misread the value.

This is exactly what happened to me. I went to an adviser in 2014 when the NZ market was going strong. I wanted to invest my money into shares in search of higher returns. My adviser tried to steer me away from investing a lump sum in shares because they (along with many other commentators) believed the market was about to go down. 4 years later and I am glad I didn’t heed their advice. I invested anyway, and the market has been on an upward bull run for the last 4 years.

Anyone can say the market will go down. But no one can say when.

If you are not comfortable with the guesswork and risk of fundamental and technical analysis, there is a third method used for buying shares.

 

3/. MODERN PORTFOLIO THEORY (MPT)

MPT investors construct their portfolios in a way that they can maximise their return given a certain level of risk. MPT focuses not on picking the right stocks, but on picking the right combination of stocks.

MPT says that the market is hard to beat and that high risk can be managed with appropriate levels of diversification and rebalancing. This theory is based more on our personal investing goals.

By following our goals we can invest depending on the stage in our life cycle. The longer we are investing for the more risk we carry. Dollar cost averaging, rebalancing and diversification can help to reduce risks. Key point is what is your tolerance for risk – this should match your goals.

The rise of low cost index funds that track different markets is on the back of the popularity of MPT and minimising risk. Stay tuned for the next article in the investing for beginners series on how to minimise risk to make the sharemarket a less scary place.

 

FINAL THOUGHTS

Countless studies have been done that show that the market, more often than not, performs better than individual advisers. Any adviser can beat the market in any given year. The longer the timeframe is extended though, the lower the percentage of advisers outperforming the market becomes. This is because today’s hot stock picker is often tomorrow’s forgotten picker.

The other thing the fund managers forget to tell you when they give you their performance statistics are that they often drop poor performing stocks from their portfolio. But they don’t include those poor performing statistics in their summary, bringing their ‘returns on paper’ up.  It is like that stock never existed.

Don’t get me wrong, there is still a place for personal investing or mutual fund advisers in any portfolio, but maybe just a portion.I explain why in parts 9 and 10. If you do want a bit of excitement and risk in your investing by stock picking maybe set a limit, say 10% of your portfolio. Then if it doesn’t work out you are only losing a small percentage of your portfolio. Diversification is king.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here