This post will focus on where our negative emotions come from, why we should be skeptical of our emotions when it comes to investing, and the benefits of overcoming our current emotional state in favor of a longer term view. Many people have a total intolerance for pain, current discomfort, and near term uncertainty. Overcoming our natural aversion to these things will make us better investors.
Intrinsic Value – Basics of Valuation
The mistake a lot of investors make is not conducting their investment work on the right “level”of analysis. Focusing on the right level of analysis is important to properly frame the investment decision and help to determine what information is actually relevant. Many investors either focus on things that are far too “big” or they misplace their attention on the incredibly “small.”
The primary unit of analysis should be the business with some additional analysis given to the industry in which it operates. By focusing on the business as the unit of analysis, investors help narrow their focus to a manageable set of information that is most closely linked to the long term success of the stocks they own.
Leverage in and of itself isn’t bad, but it must be carefully considered. It can become a problem either because investors never take the time to properly consider it or because investors over use leverage in an attempt to increase their returns. The over use of leverage is the ultimate financial temptation. It is especially tempting when times are good and the economic outlook is nothing but optimistic. It is also tempting to over use leverage when everyone else is doing it and you begin to feel you are being left behind. But leverage can be dangerous, especially at extreme levels. There is hardly a single example of a major financial implosion that didn’t involve the over use of leverage.
By Dan Erdle
Introduction
The Pareto Principle, known more popularly as the 80/20 rule, states that 80% of results are explained by only 20% of the inputs. Only a small amount of our time, energy, money, and decisions are responsible for a large amount of our outcomes. The Pareto principle also means that we waste much of our time on things that don’t really matter. In trying to explain the world around us we easily become distracted by noise. Instead, in trying to understand the world, we should focus our attention on figuring out the small number of things that lead to disproportionate payoffs.
By Dan Erdle
Overview
The modern way to approach risk, and the one used by the financial industry, is to define risk as volatility. If something moves up or down a lot, that means it is risky. The financial world has even come up with a mathematical way to measure risk called beta. If you take a finance class or hang around hedge fund professionals, you will learn all about mathematical formulas involving beta and how beta (volatility) determines how risky a financial asset is.
There are two things you can do with your money: 1) allocate it to things you want in the present or 2) allocate it to things you are going to want in the future. The choice is between getting a reward today or getting a potentially larger reward at a future date. This is the choice between consumption and investment.
Appreciating the effects of compound returns is one of the basic building blocks of becoming a great investor. Our ability to create wealth over a lifetime is the direct result of the amazing power of compound interest. For instance if we were to put $1000 in an account for a child born today, and that person lived a normal lifespan of around 80 years, while earning a 10% return, that simple $1,000 would grow to over $2,000,000.
Compound interest is an incredible concept to have working on your side. Albert Einstein is even said to have called compound interest the 8th wonder of the world. As investors we should try to understand compound returns to make sure we are doing everything we can to enjoy its benefits. If we are able to develop the correct tools as investors to achieve strong returns and have the willpower to stick with it over the long term, the mathematics of compounding take care of the rest.
In this article I will explore the interconnected relationship between investment multiples, the yield on that investment, and the rate of return investors should expect. My overarching view is that even though investment multiples are much more commonly used in the financial world, I would urge investors to instead do their thinking in terms of yield. Yields are more simple and explicit than using multiples, and using yields allows easier comparison across investments. I end the article by recommending investors use free cash flow yield in their decision making.
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