Thursday, May 20, 2010

Stock Investment: Rule No. 3

Perhaps my portfolio performance has won some trust from my friends. One day they ask, "what stock are you looking at right now?" and I say "company A looks interesting". They went on to ask "so you think the stock price can rise?" . And I go errr........

Well, before I would go into the details, I think it is important to those who are new to stock investment or who are already into it to understand the two graphs below.

What can you see from the graphs above? Can you tell the difference? Both are graphs of the same company, but how are they related?

If you can answer the first graph tells you about people's feeling/emotion and the second one is the actual business performance of the company, then you can skip the rest of this post. :)

But if you can't, you might want to consider reading some books from the gurus or leave stock investment altogether. The reason I am telling you this is because you could burn your hard earn money if you aren't able to pick up this concept. And it is not just me telling you this, the gurus as well.

The second graph tells you about the business performance of that company so far; how much it earns Or is the company fundamentally doing well Or more importantly, does it earns money in the first place.

The first graph is generally investment community feelings towards Company A or stock A (some of them may not even know the name of the company). It is how they feel about the future potential of the company AND how its price will move AND how they feel the company is worth AND how much it needs to tempt the current shareholders to sell their shares AND it is so complicated.

So are they related? NO......and yes. Okay, before I start to confuse you all, a stock price of a company is about people's feeling. And it can correctly price a company as well as mispricing it. The price can go as high as the sky when people feel good about it more than what it fundamentally worth (bubble), and can go extremely low when people feel bad about it (depression). So now you can see, it doesn't matter how the company performs, the price fluctuates as how people feel about it.

So, should we invest base on a Stock historical price pattern? Absolutely NO. There is no way one could tell how people would feel tomorrow, next week, next month or so. Even a doctor or a psychiatrist finds it hard to understand human's brains and emotions. Nor a genius like Sir Isaac Newton could tell. Sir Issac Newton: "I can calculate the motions of heavenly bodies not the madness of people". Well, nor the gurus could....

I agree that from our standpoint, we could only profit when the price appreciates or depreciates (if you into shorting). But that doesn't mean one should focus solely on the stock price when making an investment decision. Let's say if you own a coffee machine and by selling coffee made from that machine earns you RM2k every year. Would you sell the coffee machine for RM1k? My point is that even if a price of a company stays stagnant for years, and if that company grows, its earnings will eventually catch up with its price and it no longer makes any sense to sell at that particular price. And the investment community will eventually adjust its pricing. That is when the two graph becomes related. People can become crazy at times but not all the time.

The question is how do you know how the company will perform. Simple, do research on the business not the price. Like what Benjamin Graham wrote "investment is the most intelligent when it is most businesslike". Did Warren Buffett talk about stock price? Does Philip Fisher? How about Peter Lynch? An investor is people knows about the business they are investing in. This link has an interesting read:

The moral of the story one can stop monitoring the price at work (I know it is fun), do your research, make your investment and have a good night sleep.

Wait, this is rule No.3, where is rule No.1 and 2 then? Rule No.1 and 2 are from Buffett and Graham.
Rule No.1: "Don't make losses"
Rule No.2: "Don't forget rule No.1"

Who are the gurus?
Benjamin Graham, Warren Buffett, Philip Fisher, Peter Lycnh.

Happy investing :)

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