One Up on Wall Street #1
Preparing to Invest
Before you think about buying stocks, you ought to have made some basic decisions about the market, about how much you trust the corporate background, about whether you need to invest in stocks and what you expect to get out of them, about whether you are a short-or long-term investor, and about how you will react to sudden, unexpected, and severe drops in price. It’s best to define your objectives and clarify your attitudes (Are stocks are riskier than bonds?) beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss. It is personal preparation, as much as knowledge and research, which distinguishes the successful Stock picker from the chronic loser. It is not the stock market nor even the companies themselves that determine an investor’s fate. It is the investor.
Passing the Mirror Test
“Is Costco a promising investment?” isn’t the first thing I’d inquire about a stock. Even if Costco is a promising investment, it still doesn’t mean you ought to own it. There’s no point in studying the financial section until you’ve investigated the nearest mirror. Before you buy a share of anything, three personal issues ought to be addressed: (1) Do I own a house? (2) Do I need the money? and (3) Do I have the personal qualities that will bring me success in stocks? Whether stocks make good or bad investments depend more on your responses to these three questions than on anything you’ll read in The Wall Street Journal.
(1) Do I own a house?
A house is a great investment because a house is entirely rigged in the homeowner’s favor. The banks let you acquire it for 20 per cent down and in some cases less, giving you the remarkable power of leverage. (True, you can buy stocks with 50 per cent cash down, which is known in the trade as “buying on margin,” but every time a stock bought on margin drops in price, you must put up more cash. That doesn’t happen with a house. You never have to put up more cash if the market value goes down, even if the house is in the depressed oil patch. The real estate agent never calls at midnight to announce: “You’ll have to produce twenty thousand dollars by eleven A.M. tomorrow or else sell off two bedrooms,” which frequently happens to stockholders forced to sell their shares bought on margin. This is another great advantage of owning a house.)
Because of leverage, if you buy a $100,000 house for 20 per cent down and the value of the house increases by five per cent a year, you are making a 25 per cent return on your down payment, and the interest on the loan is tax-deductible.
Plus, the house is a perfect hedge against inflation and a great place to hide out during a recession, not to mention the roof over your head. Then in the end, if you decide to cash in your house, you can roll the proceeds into a fancier house to avoid paying taxes on your profit.
The customary progression in houses is as follows: You buy a small house (a starter house), then a medium-sized house, then a larger house that eventually you don’t need. After the children have moved away, then you sell the big house and revert to a smaller house, making a sizable profit in the transition. This windfall isn’t taxed, because the government in its compassion gives you a once-in-a-lifetime house windfall exemption. That never happens in stocks, which are taxed as frequently and as heavily as possible.
You can have a forty-year run in houses without paying taxes, culminating in the sweetheart exclusion. Or if there are any taxes to be paid, by now you are in a lower tax bracket, so they won’t be so bad.
There are important secondary reasons you’ll do better in houses than in stocks. It’s not likely you’ll get scared out of your house.
Houses, like stocks, are most likely to be profitable when they’re held for an extended period. Unlike stocks, houses are likely to be owned by the same person for several years — seven, I think, is the average. Compare this to the 87 per cent of all the stocks on the New York Stock Exchange that change hands every year. People get much more comfortable in their houses than they do in their stocks. It takes a moving van to get out of a house, and only a phone call to get out of a stock.
Finally, you’re a good investor in houses because you know how to poke around from the attic to the basement and ask the right questions. You checked into the public services, the schools, the drainage, the septic perk test, and the taxes. You remember rules such as “Don’t buy the highest-priced property on the block.” You can spot neighbourhoods on the way up and neighbourhoods on the way down. You can drive through an area and see what’s being fixed up, what’s run-down, how many houses are left to renovate. Then, before you make an offer on a house, you hire experts to search for termites, roof leaks, dry rot, rusty pipes, faulty wiring, and cracks in the foundation.
No wonder people make money in the real estate market and lose money in the stock market. They spend months choosing their houses, and minutes choosing their stocks. In fact, they spend more time shopping for a good microwave oven than shopping for a worthwhile investment.
(2) Do I need the money?
It makes sense to review the family budget before you buy stocks. For instance, if you’re going to have to pay for a child’s college education in two or three years, don’t put that money into stocks. Let’s say you’re a widow and your son Dexter, now a sophomore in high school has a chance to get into Harvard — but not on a scholarship. Since you can scarcely afford the tuition as it is, you’re tempted to increase your net worth with conservative blue-chip stocks.
In this instance, even buying blue-chip stocks would be too risky to consider. Absent a lot of surprises, stocks are relatively predictable over ten to twenty years. As to whether they’re going to be higher or lower in two or three years, you might as well flip a coin to decide. Blue chips can fall and stay down over a three-year period or even a five-year period, so if the market hits a banana peel, then Dexter’s going to night school.
Now you’re an older person who needs to live off a fixed income, or a younger person who can’t stand working and wants to live off a fixed income from the family inheritance. Either way, you should stay out of the stock market. There are all kinds of complicated formulas for figuring out what percentage of your assets should be put into stocks, but I have a simple one, and it’s the same for Wall Street as it is for the racetrack. Only invest what you could afford to lose without that loss having any effect on your daily life in the near future.
(3) Do I have the personal qualities it takes to succeed?
This is the most important question of all. It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit to mistakes, and the ability to ignore general panic. In terms of IQ, the best investors fall somewhere above the bottom ten per cent but also below the top three per cent. The true geniuses, it seems to me, get too enamoured of theoretical cogitations, and are forever betrayed by the actual behaviour of stocks, which is more simple-minded than they can imagine.
It’s also important to be able to make decisions without complete or perfect information. Things are rarely clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.
And finally, it’s crucial to be able to resist your human nature and your “gut feelings.” It’s the rare investor who doesn’t secretly harbour the conviction that he or she has a knack for divining stock prices or gold prices or interest rates, even though most of us have been proven wrong again and again. It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs. This is borne out by the popular investment-advisory newsletter services, which themselves tend to turn bullish and bearish at inopportune moments.
The problem isn’t that investors and their advisors are chronically stupid or unperceptive. It’s that by the time the signal is received, the message may already have changed. When enough positive general financial news filters down so that the majority of investors feel truly confident in the short-term prospects, the economy is soon to get hammered.
Things inside humans make them terrible stock market timers. The unwary investor continually passes in and out of three emotional states: concern, complacency, and capitulation. He’s concerned after the market has dropped or the economy has seemed to falter, which keeps him from buying good companies at bargain prices. Then after he buys at higher prices, he gets complacent because his stocks are going up. This is precisely the time he ought to be concerned enough to check the fundamentals, but he isn’t. Then finally, when his stocks fall on hard times and the prices fall to below what he paid, he capitulates and sells in a snit.
Some have fancied themselves “long-term investors,” but only until the next big drop (or tiny gain), at which point they quickly become short-term investors and sell out for huge losses or the occasional minuscule profit. It’s easy to panic in this volatile business.
Some have fancied themselves as contrarians, believing that they can profit by zigging when the rest of the world is zagging, but it didn’t occur to them to become contrarian until that idea had already gotten so popular that contrarianism became the accepted view. The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e., shorting a stock that everyone else is buying).
The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.
