In Risk Allows You to Make Money in the Stock Market, I talked about how taking risks is what allows you to make more money investing in stocks than you could earn from a bank account. Because you are putting your money at risk, the price you pay for shares of a stock are reduced (or discounted in accountant speak) from the price they would be at if you were assured that the company would make the earnings expected and pay those earnings out in a dividend. You might get a check for $100 per year for your $1000 investment, or a 10% return, but you might not. You would therefore invest only $500 and still expect a $100 per year payment if the business does well and things work out. You get a higher return (20% instead of 10%) to make it worth taking the risk.
Luckily, with the market-based system you don’t need to figure out the right price to pay to get an appropriate risk premium. Smart people with sophisticated computer programs do that for you by buying shares if they are cheap and selling shares if they are expensive. As a result, the price of a stock will generally, but not always, already contain an appropriate discount for the amount of risk you are taking. To improve your chances of getting a good price, you can also follow the share prices for a few weeks before you make a purchase and try to buy when the stock is it the low end of the range. This can be done easily by placing a limit order, where you set the maximum price you are willing to pay for a stock. You can also look at the price-earnings ratio, or PE, or the price to sales ratio, or PS, and only buy stocks that are at or below their average PE or PS level, averaged over the last several years. In general, because I am buying for the long-term, I don’t worry too much about getting an extra ten cents or quarter per share since it won’t really matter in the long run and I may miss out on a big move up if I’m too picky. Instead I tend to pick stocks from my watch list that have declined in price recently by at least a few dollars when I have money to invest and am ready to buy more shares.
In Risk Allows You to Make Money the Stock Market I gave three ways to help manage risk and put the odds on your side. These were:
1. You invest appropriately for the time frame you have.
2. You diversify your investments to reduce single-investment risk.
3. You choose your investments appropriately based on your time frame and objectives.
Today I’ll cover the first item, investing based on your time frame.
The more volatile the investment you’re making is, the less able you are able to predict future values. If I put $1000 in the bank in a CD paying 5% per year, I can predict with almost certainty that I will have $1050 in a year. If I put $1000 in a stock that I think has the potential to grow earnings by about 15% per year, I have no clue what the price of the stock will be in a year. I might have $2000. I might have $500. All that I know for sure is that I’ll lose $50 or so immediately due to transaction costs and brokerage fees.
The company I invest in may have a bad quarter, miss earnings estimates, and fall 20%. The economy in general may run in troubles and the stock price may fall. A competitor in the same industry as the stock you purchased may run into trouble and people may sell stocks in the whole industry. The company may even post record earnings, but those earnings may be less than the “whisper numbers” some people may be expecting, and the price of the stock may fall.
While it is hard to time when the price of a company may go up, it is reasonable to expect that the stock of companies that are run well and are growing will increase in price at a rate about equal to the growth rate of their earnings. This will be in fits and starts, with some declines or even crashes along the way, but over long periods of time you should be able to get a fairly predictable rate of return. It might be that the stock doubles the first year and then trades within a range over the next few years, it might be that the stock price increases steadily each year, or it might be that it goes nowhere for several years and then doubles in price.
The way to manage the risk that the stock price may not increase over short periods of time is to simply only buy stocks if you are planning to invest for a long period of time. For mutual funds I’d be reluctant to invest unless I was planning to invest for at least five years and maybe ten years or longer. For individual stocks I’d probably be looking at ten years or more. This gives time for the company to grow and people to realize that it is a great company and bid up their stock price. I don’t have to guess what will happen with the economy, people’s emotions, or understand what trading strategies people are employing will do to the price over any given period. I just know that if I wait long enough, things should work out and I should get the return needed to justify the risk I am taking.
I therefore would use the following guidelines:
1. For cash needed within six months, use a bank account.
2. For cash needed in one to three years, invest in bank CDs or perhaps high quality bonds set to be redeemed within the period.
3. For cash not needed for five to ten years, split the money between stocks, bonds, and cash, and use mutual funds to diversify.
4. For cash not needed for a decade or more, invest in stocks through mutual funds and select individual stocks.
By using time to put the odds in your favor, you can get greater returns by collecting the risk premium.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.