Today we’re starting with a common question, and we’re going to answer it from a few different points of view. College student Cesar asked me, “Jesse, take a look at my investments. Do you think they’re good?” Sounds like simple enough: are my investments good?
But there’s more to the question than meets the eye, so let’s get to work.
Why are you investing?
Cesar is a college sophomore, 20 years old. His current portfolio is a collection of 5 individual stocks from 5 different companies, totaling about $500 in value.
If Cesar is investing for retirement, then $500 is perfectly good first step. But just a first step. Why? Well, even if Cesar’s portfolio doubled every seven years—which would be better than average—he’d end up with about $32,000 at age 62. $32K is nothing to scoff at, but it’s also not enough to retire on. Cesar should keep on taking those steps though, especially when he’s young.
If Cesar is investing for fun, then what he’s doing is great. If you can, I highly recommend using a small amount of money to hand pick stocks. Odds are, you’ll do poorly. But it will be a valuable lesson! Hand-picking stocks is hard, and you’re probably not smarter than the market. Some people never learn this lesson. Others learn it at age 50, with hundreds of thousands of dollars on the line. Cesar might learn this at age 20, and might lose $50 or $100. It’s an incredible lesson for $100.
If Cesar is hoping to turn $500 into $600 for next semester’s text books, then what he’s doing is very risky. Short-term investing for near-future expenses has just as much chance of succeeding as it does of blowing up in your face. He’s as likely to end up with $400 as $600, especially considering the trading fees that might eat into his potential profits. There are much lower-risk investments—high-yield savings or certificates of deposit—than can provide solid returns (2-3%) over short periods.
When you invest, you should know what your goals are. Only then can you start to understand if your investments are “good.”
Are Cesar’s stock choices “good”?
I already mentioned my thoughts on hand-picking stocks, but I’d like to provide some more insight into this.
Why did Cesar choose his five companies? And why did he purchase those companies at their specific prices? As an example, let’s look at Cesar’s ownership of Wal-Mart.
One possible explanation is: “I chose to invest in Wal-Mart because it’s a well-known company. I purchased it at $110 because that’s what it was trading for on the day I decided to purchase it.” Seems perfectly reasonable.
Another possible explanation is: “I conducted an analysis on all of Wal-Mart’s relevant financial metrics, and I valuated the company at $130 per share. So when I saw that the price was only $110 per share, I knew it was a great deal.” That seems…better. Why?
The first explanation is based on opinion, emotion, and is dictated by the market’s value.
The second explanation is based on finances, facts, and is dictated by the company’s true value.
Buffett and baseball
Warren Buffett–who constantly ask himself ‘are my investments good?’–uses an excellent baseball analogy to expand this idea of when to pull the trigger and buy. If you don’t like a pitch in baseball, you can choose not to swing at it. But if that pitch is in the strike zone, then it counts against you. Three strikes, you’re out. Therefore, you might end up in a situation where you have to swing at a pitch even if you dislike it, simply because it’s a strike. You’re forced to pull to trigger and swing.
Well, Buffett likes to point out how investing doesn’t work this way. Every day, the markets throw thousands of pitches at you. Apple at $230, Ford at $9, Wal-Mart at $110. You don’t have to swing at—or buy—any of them. You can wait, and wait, and wait. You’ll never get a strike called on you. “Investing is a no called-strike game,” as Buffett would explain. But when that perfect pitch comes…BAM!…you can knock it out of the park.
If you do your homework—financials, facts, true value—you might find that Wal-Mart is worth about $115 a share. The market throws you pitches over days, weeks, months, but you don’t like any of them. Then don’t buy! But one day, the market price drops to a sweet spot–maybe $105–and you think, “This is a good pitch. I know I can profit off of this deal.” Then swing away!
The Lazy Person’s Homework
Did Cesar do this kind of homework? Maybe! Or maybe not. I certainly know that I don’t do that level of homework. I don’t have the time, nor the expertise. Do you? Good news: in investing, a lazy person doesn’t necessarily have to worry “are my investments good?”
I do know that there are thousands of professionals who do this homework every day. They work at banks, hedge funds, pension groups. And the funny thing is, they come up with different answers from one another. Why is Apple selling for $230 today? Because about half the experts think that buying at $230 is the smart move, while the other half think that selling at $230 is the smart move. That’s how prices are determined…where the supply (the sellers) meets the demand (the buyers). They come together, and the deals the make occur right around the $230 point.
Since the experts can’t make up their minds about whether today’s price is a good buy or good sell, I invest in index funds, where I buy a small portion of the entire market, regardless of price. I can’t tell the difference between good pitches and bad pitches, so the market throws me average pitches every single day. I don’t have to make the hard choices about what individual companies to buy, because I invest in the economy as a whole.
Whether you’re Princeton scholar Burton Malkiel or call yourself a “Boglehead,” index funds are pretty good for simple, average investors. After reading their books, the benefits and strategies of indexing made a lot more sense to me. I can’t do the professional’s homework, so I do the lazy person’s homework instead.
So, back to the beginning: “are my investments good?”
Why are you investing? What’s your goal?
How are you investing? What pitches are you swinging at?
Thanks for reading the Best Interest.
PS: You might have noticed how often my readers influence what I write about. If you have a question or thought, I’d love to hear from you!