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What Every Stock Investor Should Know
Some people think that investing requires a vast number of specialized skills, that are only achievable by professionals. The truth is that anyone can succeed as an investor, assuming they are willing to make the effort.
Although the amount of obtainable knowledge is endless, there are a few essential things every stock investor should know.
Understanding Financial Statements
Reading and interpreting financial statements is a skill every stock investor should know. There are three main financial statements, which I like to call the crucial three:
Income statement
Balance sheet
Cash flow statement
They tell you whether the company has made any profit, does the company have more assets than liabilities, how much cash the company has generated, and how it has been allocated.
In other words, they indicate whether the company is a good choice for investment or not.
All three can be found in the company’s quarterly and annual reports – which are by far your most important source of information.
Remember, that an investment decision made without any knowledge about the company’s financials is merely speculation. You should aim to be an investor, not a speculator.
Economy and Business
To put all the information from financial statements to use, you should have a general knowledge of how the economy works. A business cannot operate outside the economy. Depending on the nature of the business, the impact of economic cycles can vary greatly.
Cyclical companies are more vulnerable to economic cycles than defensive companies. They produce goods that have increased demand in economic upturns and decreased demand in downturns. The less risk an investor prefers, the more defensive stocks should she pick.
For an investor, it is essential to understand the connection between inflation, interest rates, and the stock market. Usually, rising inflation leads to higher interest rates, which in turn decreases stock prices.
This happens mainly because of two reasons. First, investors start to pull their money from the stock market and shift towards bonds, which leads to decreased demand and lower stock prices.
Second, the price of debt rises, which means that the future cash flows of companies are reduced. Therefore, the price investors are willing to pay for a company is decreased accordingly.
This is one of the reasons why central banks draw so much attention when they announce whether they raise the interest rate or not.
One of the greatest presentations about the workings of an economy is How the Economic Machine Works by Ray Dalio: How the Economic Machine Works. I cannot recommend this enough.
The Nature of Markets
As an investor, you should have a general knowledge of the nature of markets. It is normal for markets to fluctuate. There have always been and always will be ups and downs that are linked to the economic cycles, world events, and investor behavior.
One of the main things to understand is that markets are not always rational. Stock prices rise too high and fall too low. The irrationality is emphasized in the short term, but in the long term, a sliver of sanity might be found.
Markets tend to overreact on the short term, which can lead to tempting investment opportunities. If you find a company that you believe to be undervalued, it requires a great amount of patience to wait for the stock price to reflect the company’s fundamentals. That’s one of the reasons why investing long-term is often so challenging.
Another important thing to accept is that you can’t predict the markets. None of us can. This makes timing your transactions extremely hard. There are things you know, things you know you don’t know, and more importantly, things you don’t know you don’t know.
It is helpful to realize, that the human mind is not really built for understanding long-term concepts.
We tend to overestimate short-term and underestimate long-term effects. Therefore, markets often seem especially irrational and confusing when followed day-to-day basis.
The best way to deal with the madness of the crowds is to stay away from daily financial news and stick to quarterly and annual reports. Financial news is often for entertainment and sales, not for relevant information.
The Relationship Between Risk and Reward
One of the universal truths of investing is that higher returns equal higher risk. One of the cornerstones of successful investing is to define your risk profile.
Taking too much risk will not only compromise your financial well-being but will also hamper your long-term investing goals. When your risk level is too high, you tend to make poorer decisions and might, for example, be forced to sell your stocks at an unfavourable time. In other words, taking too much risk will hamper your long-term investing goals.
On the other hand, your risk level can be too low compared to your expected returns. Over the last 200 years, the average stock returns have been around 6.5 to 7 percent.
If your goal is to beat the market and earn an above-average market return, you will not achieve it without taking additional risk.
Generally speaking, your risk level should be determined by your time horizon, life status, and investment goals.
Human Behaviour
Behind every investment decision, there is always a human mind. Numerous studies have shown that we’re not the rational beings we often believe ourselves to be.
You should be aware of your strengths and weaknesses. This requires immense amounts of honesty and self-awareness since we usually tend to be blind to our own flaws.
There are several cognitive biases, like overconfidence and confirmation bias, that every investor should be aware of. The important thing about biases is to recognize them and act accordingly.
In my experience, the biggest mistakes investors make are related to risk assessment and predicting their own behaviour. The problem is that we rarely know our behaviour beforehand, even though we would like to think we do.
People tend to believe they can manage more risk than they are actually comfortable with. This impacts their behaviour and usually results in unnecessary back-and-forth trading and diminishing returns.
One of the most challenging things about investing is to maintain your own rationality during the peaks of bull and bear markets. It is not uncommon for an investor to wildly overpay for a stock because everyone else is buying it too, thus bidding the price too high and earning poor returns.
It is equally foolish to sell your stocks during a bear market if the companies themselves are fundamentally sound.
The best way to prevent foolish decisions is to take a reality check before making an investment. You should invest only when you find a genuinely good opportunity, not because of fear or greed. It is helpful to know and understand, that the greatest stock market manias and crashes are the results of hubris and hopelessness of the masses.
Summary
So, there were the 5 essential things that every investor should know. The successful investor should learn how to understand a company’s fundamentals, and how they are affected by changes in the economy.
In order to make successful investment decisions, an investor must know how the markets work.
The relationship between risk and reward is one of the elementary concepts in investing – one that every investor should understand thoroughly.
Despite all the numbers and analytics, investing is a surprisingly humane activity. To really understand investing and markets, you must understand human behaviour. In the end, it is humans that make the market.
One of the greatest challenges you will confront as an investor, is to accept and deal with uncertainty. No matter how well you do your research you will never be able to predict the future.
You can spend decades learning about investing and still make blunders that you’d rather tell no one. On the other hand, you may change your whole life through investing.
Sometimes investing can be a grueling journey of euphoric highs and intolerable lows, but I promise you, it will be worth it.
