If you must invest money in something other than index funds your best bet is probably value investing. Value investing is the theory that you should invest in a stock or bond based on the value of the underlying company (imagine that). If the value of the company divided by the number of shares outstanding is greater than the price of a share, the stock is undervalued and you buy it. This is different than momentum investing, which buys stocks which are going up, figuring that they will keep going up. This is also different than investing based on “technicals” which seeks to figure out patterns from previous stock prices then make a profit buying or selling based on those patterns. Investing based on technicals (basically staring at stock charts) is a scam. I will happily bet anyone investing on a technical basis that they will under-perform when measured against a benchmark. There is some evidence that stocks exhibit some momentum. Unfortunately, the effect is small enough that after transaction costs and taxes you can’t actually make a profit off of it.
Where to start
- The Intelligent Investor by Benjamin Graham
- Benjamin Graham is known as the father of value investing, and for good reason. Benjamin Graham gives the reader with a powerful thought experiment. Many people worry when the shares of stock they own go down. Graham argues that rather than thinking of the stock market as reflecting the true value the shares of stock you own, you should instead think of the stock market as a manic depressive partner. Imagine that you are part owner of a business. Every day your partner (Mr. Market), comes to you and offers to either sell his share or buy your share at prices that fluctuate based on his mood. Graham argues that you should look at your partner as a benefit, rather than letting his mood-swings give you mood swings. When Mr. Market is too pessimistic and he offers to sell you his shares for too low a price you get the opportunity to buy them, when he is too optimistic and offers to buy your shares for more than they are worth you get to sell them.
- Security Analysis by Benjamin Graham
- This guy again. You may have noticed a slight problem with this whole plan. If we’re going to buy stocks when their prices are below their intrinsic value, how the heck do we calculate this intrinsic value? The value of a business in principle is the sum of all the cash you can take out of the business for the next forever, discounted to its present value. (Discounted by what you ask? The theory here is that $1 next year is worth less than $1 today. The amount that it is worth less is determined by your next best investment opportunity. If you have another way of investing money that returns 5% annually, a dollar next year is worth ~5% less than a dollar today.) Security Analysis is all about conservatively estimating how much of that future cash there will be, if there is any at all.
Read both of these books and you’ll be well on your way to understanding value investing as a strategy. There’s still a great deal more to learn. Since Graham wrote these books investing has gotten much more competitive. While if you carefully employ the tools given by Graham you will likely see a profit, we still have a long way to go in the investing world. If I may make a comparison to physics however, in order to understand how the universe works there’s Einstien and Quantum Mechanics and all kinds of complicated things, but if you understand Newton you’ll get most of the broad strokes. You also have to start with Newton. Anyone who acts like they understand quantum mechanics but don’t understand that F=ma is a liar, a charlatan, or a journalist. For investing we start with Graham.