But risk should be defined as a level of uncertainty. And the more uncertain you are about what you invest in, the more risk that you take. For example, it is risky to marry someone that you know little about. And so to successfully achieve a reasonable return in the stock market, you should be aware of what you do not know.

Written by:

Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential. Click here for frequently asked questions.

I'll be yours forever

Just like real life - there are plenty of myths on Wall Street

August 24, 2018

1. Risk and Return

Common convention is that to earn a reasonable return in the stock market you need to take risk. This belief results in investors purchasing stocks that operate industries they know little of, hoping that this assumption of the relationship between risk and return will prevail as a given law.

Wall Street prefers to see risk as the relationship of a stock price to the overall price of the stock market. Known as Beta, the idea goes as follows: if a certain stock goes up in price while the overall stock market increases then Beta is positive. If the price of the stock declines as the price of the overall stock market increases then Beta is negative. With this naive definition of risk in mind, your stock advisor may suggest that if the price of the overall stock market is going up, then you will be better off purchasing high Beta stocks.

But risk should be defined as a level of uncertainty. And the more uncertain you are about what you invest in, the more risk that you take. For example it is risky to marry someone that you know little about. And so to successfully achieve a reasonable return in the stock market, you should be aware of what you do not know.

A suggestion: One of the ways to become knowledgeable about a publicly-traded company is to read its public filings. Visit the Investor Relations section of their website to read more about the company’s strategy, competition and past operating results.

2. Relative Versus Absolute Comparison

Value in the stock market is measured both by relative and by absolute comparison. An example of a relative valuation is to compare the current price of a stock with the overall price of the stock market. An example of an absolute valuation is when a stock investor purchases a stock only if the current earnings multiple is no greater than 10 times the prior year's earnings.

Today the discussion around the purchase of a stock evolves around relative valuation. How did Samsung perform when compared to Apple. And whether Apple's earnings this year were higher compared to last year. 

But there are two weaknesses to using relying on relative valuation. The first weakness is that there is no maximum price that an investor will pay for a stock. The second risk is that a constant comparison to others promotes short term thinking. One day you feel great because the quoted price of a stock is up. On other days you feel glum because its price is lower. And mood swings do not promote rationale thinking.

A suggestion: Delete from your phone any applications that track on a daily basis the price of your stock portfolio.

3. Money Managers

According to Statista, a website dedicated to data gathering, there are 9,000 mutual funds to choose from. The story -- why you would want someone else to manage your money -- goes like this: You are busy. With so much to do and so little time. And since stock investing requires knowledge, skill and evidently time, you are told to trust a mutual fund manager to do the work for you.

But your interest and your manager's interest are not always aligned. Most managers strive to augment the size of the assets they manage. This is because the greater the size of the mutual fund the greater the management fees. But the more capital a mutual fund has, the more the likely it is that its performance will be penalized. Warren Buffet often commented on this phenomenon in his letters to shareholders. His own words in 1985:

"Our equity capital is more than twenty times what it was only ten years ago. And an iron law of business is what it growth eventually dampens exceptional economics. Just look at the records of high-return companies once they have amassed even $1 billion of equity capital. None that I know of has managed subsequently, over a ten-year period, to keep on earning 20% or more on equity while reinvesting all or substantially all of its earnings. "

A suggestion: Refrain from investing in mutual funds where the managers have little of their capital invested in the mutual fund. And avoid any manager that charges a management fee higher than 1.0%. You will be better off with a passive investing strategy such as purchasing in an exchange traded fund.

4. Speculation Versus Investment

"Investments throw off cash flow for the benefit of the owners," wrote Seth Klarman in Margin of Safety. "Speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market."

What Klarman suggested is that there are two types of assets: an investment and a speculation. An investment is an asset that yields cash flow (think rental income generated from renting a condo). And speculation is simply any other asset that does not meet the definition. Accordingly, Bitcoin and gold are speculative assets. This implies that when you save for retirement, or for the education of your children, you must invest and not speculate in the stock market. 

A suggestion: How and whether a business generates cash flow should be the first question you ask prior to buying in its stock. 

5. The Nature of the Brokerage Business

Just as you would be skeptical of an advice about how to gamble given by a poker table dealer, you should refrain from taking to heart advice from financial brokers. The nature of these financial intermediaries is that they are hungry to earn commissions. Read: most brokers prefer a frantic, stock trading behavior than a lethargic one. 

In addition the broker does not know you. Each investor has a specific time horizon, tax situation, risk and return objectives and unique financial circumstances that must be considered prior to making an investing decision.  A recently-wed couple for example, who would like to purchase their first home in 9 months, has a different time horizon than an individual who would like to invest in the stock market and is not planning to use the money before retirement.   

A suggestion: Stop listening to commentaries about the stock market from people that don't know you.