Source: Foxy Monkey
1. Price is what you pay, value is what you get
The relationship between price and value is probably what separates superior investors from below-average ones. It’s not an easy task and the relationship changes over time.
Take flights for example. I fly on 7A and have paid £200 when the person at 7B has paid £140 for the same exact flight. Maybe they booked it earlier, maybe not. Maybe the airline’s algorithm determined that in my area people are more wealthy and it should charge them more! It doesn’t matter. What matters is that I paid more for the same value.
More extreme examples come to mind, such as… Bitcoin. Has the Bitcoin improved so much between 2014 and 2017 to justify a 7000% increase? Probably not. People changed and learned more about it which is why hype combined with supply and demand worked out the new price.
Now you could argue that because of the bitcoin network being available to more people it is now more valuable as a product. But I doubt most people buying it were using it for what it is, a currency, rather than a way to make a quick buck. So was I!
I was trying to convince a colleague that buying Amazon because it’s a great company doesn’t necessarily mean it’s a good investment. It’s the price you pay for Amazon that matters, not only Amazon as a company. there are no good or bad stocks. Any bad company can be a good investment at the right price.
2. The most important thing is recognizing risk
Each asset like stocks bonds and property have specific expectations.
Most people think that by making riskier investments they should get higher rewards. It certainly doesn’t always work this way, otherwise risky investments wouldn’t be risky!
Also, most people believe that quality is what determines the riskiness of an investment. I’ve certainly heard:
I’ve bought Amazon, this is a low-medium risk investment,
Can’t go wrong with central London Buy To Let
3. Market Cycles Matter!
4. Having a sense of where we stand in the market cycle
- Are investors optimistic or pessimistic?
- Are they pouring market into the markets or are they avoiding it?
- Are the current price-to-earnings metrics higher or lower compared to history?
- What about yield spreads?
For example, as I’m writing this article on June 2019, the Shiller PE ratio sits around 30 – almost double its historical value! As we enter the 10th consecutive year of the bull market this metric tells us that the US market looks expensive compared to 100 years of history. The rest of the world looks fairly valued for now.
What about yield spreads? Currently, the US bonds offer a very low real return – around 2%. The spread between short-term lending (1 to 2-year bonds) and 10-year ones is very narrow.
That’s very strange as it means lenders want to lend for the longer term which pushes the 10-year prices up and their yields down. They believe the 10-year yield will become lower in the future so better buy now. This usually happens in economic slowdowns or recessions.
The UK yield curve is not much better – yielding 0.8% for 10-year gov bonds and 0.64% for 2-year ones. Another indicator of a low return environment is the dividends companies pay. For US companies (which represent around half of the global market nowadays) that’s around 1.86% at the time of writing.
This is much lower compared to the historical 4-5% companies used to pay. That’s partly because companies today prefer to buy shares back (which as a result increases their share price) then pay out dividends. Also, the high concentration of tech companies in the US stock market can partly explain why!
So if you’d ask me, where do we stand in the cycle? I’d say the 10-year recovery from the most recent financial crisis has had a great run. We’ve borrowed future returns and at some point, the music will stop. Obviously, this doesn’t mean we should not invest any more money.
We don’t really know when prices will become lower – Australia hasn’t had a recession for 28 years! But it means two things:
- we can invest more defensively than we otherwise would
- we should expect lower than average historical returns for similar portfolios
5. Bargain Hunting
The Russians have a saying: “Stingy always pays twice”. When it comes to investing, I don’t fully agree with it. I like the stingy! I like value and it’s my job as an investor to always pay less than what I’m buying. This is where the highest returns come from!
- Items not fully understood or known by everyone
- Controversial buys
- Not proper buys for “high-quality” portfolios
- Unloved and unpopular
- Poor historical returns
When I look at some great money-making investments in the past few years a lot of those characteristics come to mind! Everyone was afraid that renewable energy will take over oil plus OPEC disagreements brought its price down to 28$ a barrel in 2015.
Looking back, obviously we’re still using oil and that would’ve been a screaming buy.
Another one: Some areas in London like Peckham that were the least favorable a decade ago, only to appreciate so much lately. I’m looking at you unpopular Glasgow that you haven’t reached your 2008 house price levels yet.
I’m also thinking of some more niche investments that I could have made.
6. The most important thing is… Being a contrarian
7. Being patient
8. Respecting luck
If I learned something from the book Thinking in Bets it’s that we, humans like to judge the correctness of a decision by its outcome. But this can be very misleading. Unfortunately, that’s how people assess our life decisions.
Have many years of history before trusting something
Judge by a longer time horizon
View the future as a probability distribution
Invest defensively to minimize regret rather than maximize return
But understanding risk, where we stand in the cycle and how markets have worked in the past allows us to be a little bit more conservative or more aggressive when needed. It also helps set our expectations and not be disappointed when “10% per year from stocks” are not delivered.
For example, as we enter the 10th consecutive year of the bull market, maybe getting a sure return by overpaying our mortgage is better than investing the difference. One gives a sure return, the other relies on an expensive market to do so.