The firm foundation theory: companies have an intrinsic value. They valued based on the net present value of their current and future cash flows. This is the theory Buffett and Munger have used to build Berkshire Hathaway.Castle in the sky theory: companies have psychological value. Their value is about how others perceive their value. This theory is purported by Keynes. It’s also exhibited by the many periods of “irrational exuberance” that we’ve been through in history.

The Two Investment Theories

Fundamentalists select stocks based on a firm foundation of estimated intrinsic value. This theory suggests that stock values are roughly 90% rational and 10% psychological.Stocks increase in value with four signals:<ul><li>Expected growth rate (P/E signal of this)</li><li>Expected dividend payout</li><li>Degree of risk</li><li>Level of market interest rates</li></ul>

Fundamental Analysis

Investors have a number of mechanisms that cause them to assume a greater degree of control than they have in reality. Most investors fail to properly weight probability and use base rates.

Biased Judgments

What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.<ul><li>Avoid herd behavior</li><li>Avoid overtrading</li><li>Sell losers, not the winners</li><li>Don’t buy into IPOs or trust “hot tips”</li></ul>Everyone wants to earn more with less effort. At times, there are “get-rich-quick” schemes or trends that are incredibly tempting, but the best we can do is avoid these dangerous traps. It’s easier said than done.

How to Avoid the Pitfalls of Investor Irrationality

The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio.If you have a multi-decade investment horizon, you should be heavily invested in stocks. While stocks are more volatile than other asset classes over short investment horizons, in the long run, you’re likely to get a good return.Avoid actively managed funds with high expense ratios and turnover. These funds are everywhere, and they consistently underperform index funds.

Portfolio Composition

The rule of 72 provides a shortcut way to determine how long it takes for money to double. Take the interest rate you earn and divide it into the number 72, and you get the number of years it will take to double your money. For example, if the interest rate is 15 percent, it takes a bit less than five years for your money to double (72 divided by 15 = 4.8 years)

The Rule Of 72

People in this camp believe that there are times to buy/sell stocks based on their price movements. This theory suggests that stock values are roughly 90% psychological, and 10% rational. These people are often traders, rather than long-term investors.Two important assumptions for this theory: all news is priced into stocks, and stocks move in trends.

Castle in the Sky Theory

The many financial bubbles (periods of irrational exuberance) demonstrate how asset bubbles continue to form throughout time.<ul><li>Blue chip company booms of the 1970s</li><li>1980s biotech craze</li><li>Japan in the 80s/90s</li><li>2000s dot com bubble</li></ul>There are new technologies, business opportunities, or unique valuation criteria that lead to positive feedback loops that drive stock prices through the roof. Then there’s a 50-90% crash.

Finances Bubbles

Diversification leads to good returns with lower risk. It works when you have assets that are not perfectly correlated. For example, foreign stocks are not perfectly correlated with domestic stocks, so adding them to your portfolio can lower risk while maintaining good returns. Assets have become increasingly correlated in recent years, but as long as they are not perfectly correlated, portfolio theory is still helpful.

Modern Portfolio Theory

The efficient market hypothesis is built on the idea that investors are rational. Rational investors are individuals who make decisions that maximize their wealth, but are constrained by their individual risk tolerance. Behavioral finance questions the idea of the rational investors, highlighting that there are at least four factors causing irrational investor behavior:<ul><li>Overconfidence</li><li>Biased Judgments</li><li>Herd Mentality</li><li>Loss Aversion</li></ul>

Behavioral Finance

<ul><li>Buy companies with average expected earnings growth for 5+ years</li><li>Never pay more than foundation of value</li><li>Look for good stories of growth</li></ul>The problem is that no one can reliably assess value. There are many factors for that, so the firm foundation theory does not work reliably. Technical and fundamental analysis don’t work, and all information is already priced into the market.

Efficient Market Hypothesis: The Rational Approach

The probability that a security will decrease in value. The greater the risk, the greater the variance. Risk is the variance in the standard deviation of returns.<ul><li>Beta is systematic or market risk – it measures how a stock moves with the overall market. </li><li>Unsystematic risk – risk associated with a particular company</li><li>Diversification cannot eliminate systemic risk, but it can reduce unsystematic risk.</li></ul>

Investing Risk

Securities analysts have a heavy bias toward “buy ratings.” Something like 10:1, and it even got to 100:1 during the dot com bubble. <ul><li>Analysts work at banks that have corporate clients that would get pissed with a low rating. So incentives are aligned to favor buy ratings.</li><li>Markets can be irrational, but true value is always recognized. Market is a weighing, not a voting machine.</li><li>Investors are emotional – greedy, gambling, hope, fear – they’re not immune to this.</li></ul>

Incentives to Understand

Investors are overconfident about their beliefs/abilities and over optimistic about their assessments of the future. Investors also tend to overestimate their own skill and deny the role of chance in their outcomes. Most investors are too precise in their confidence intervals.Typically, investors attribute good outcomes to their own abilities (hindsight bias). They also attribute bad outcomes to external events.One manifestation of overconfidence is the consistent overvaluing of growth stocks.

Overconfidence

Losses hurt more than the joy we receive from equivalent gains. The pain we feel with a $100 loss is about the same as the joy we get from a $250 gain. Loss aversion explains why so many investors sell the winners and hold on to the losers. Especially when we face a sure loss, we will hold on to losers for even longer.  Even if market participants are irrational, it doesn’t mean the market is not efficient. That’s highlighted by the difficulty of consistently finding arbitrage opportunities in the market.

Loss Aversion

The value of a stock is determined by 3 factors:<ol><li>Initial dividend yield</li><li>Growth rate of earnings</li><li>Changes in valuation in terms of P/E or price/dividend ratios</li></ol>The value of a bond is determined by 2 factors:<ol><li>Initial yield to maturity at time of purchase</li><li>Changes in interest rates (yields) if you don’t hold bond to maturity</li></ol>

How Stocks and Bonds Are Valued

<ul><li>History shows that risk and return are related</li><li>The risk of investing in stocks/bonds depends on the time you hold the assets. The longer the holding period, the lower the likely variance in asset returns.</li><li>Dollar cost averaging can be a useful, though controversial, technique to reduce risk.</li><li>Rebalancing can reduce risk, and in some circumstances, increase investment returns.</li><li>You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation.</li></ul>

Asset Allocation Principles

<ul><li>Specific needs require dedicated specific assets. If you need $30,000 for a house downpayment in 2 years, you will need an investment vehicle that matches your need for that capital at that time.</li><li>Recognize risk tolerance. In general, your investments should never disturb your sleep. So invest up to your sleeping point – the point at which you can handle the day to day variance and still sleep just fine.</li><li>Persistent savings in regular amounts, no matter how small, pays off.</li></ul>

Tips To Live By

<ul><li>Cash (5%)</li><li>Bonds (15%)</li><li>Stocks (70%)</li><li>Real estate (10%)</li></ul>Invest in index-funds (low cost), and get international exposure. The US is only one third of the world economy, and other areas are growing quickly. If you hold bonds, make sure you do it in a tax-deferred retirement account.

Portfolio for Your Mid-Twenties

The core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds.We cannot consistently beat the market or achieve outsized returns, so invest in low-cost, tax-efficient, broad-based index funds. Not only is it simple, but it’s likely to give you the best outcome as an individual investor.And because of the power of compound interest, we should begin this savings and investment program as early as possible.

The Best And Safest Investment

Over short holding periods, there is some evidence of momentum in the stock market. Increases in stock prices are slightly more likely to be followed by further increases than by price declines. For longer holding periods, reversion to the mean appears to be present. When large price increases have been experienced over a period of months or years, such increases are often followed by sharp reversals.

On Stock Market Trends

If there is inflation of 2% every year, that means that you need at least a 2% return on your capital to maintain your real purchasing power. If you get no return by leaving your money in an account with no interest, your money is becoming less valuable over time. So you need an investment strategy that, at the very least, keeps up with inflation.

The Need To Invest

There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich. We all get lured into tales of people making money through investing and of the hot new stock that we need to invest in. This tendency to get swept up in speculative, get-rich-quick schemes is representative of how we get lost in herd mentality when making investment decisions.

Herd Mentality

<ul><li>Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. Growth increases, earnings, dividends, and likely the multiple the market will pay for those earnings.</li><li>Never pay more for a stock than can reasonably justified by a firm foundation of value. No perfect measure, but look at how stock trades relative to market and growth potential. Avoid stocks with many years of high growth priced in.</li><li>It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air.  </li></ul>

Stock Picking Rules

A classic guide that blends history, economics, market theory, and behavioral finance to offer practical and actionable advice for investing and achieving financial freedom.

A Best Book For Investors Pick by the Wall Street Journal’s “Weekend Investor” Whether you’re considering your first 401k contribution, contemplating retirement, or anywhere in between, A Random Walk Down Wall Street is the best investment guide money can buy. In this new edition, Burton G. Malkiel shares authoritative insights spanning the full range of investment opportunities—including valuable new material on cryptocurrencies like bitcoin, and “tax-loss harvesting”—to help you chart a calm course through the turbulent waters of today’s financial markets.

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A Best Book For Investors Pick by the Wall Street Journal’s “Weekend Investor” Whether you’re considering your first 401k contribution, contemplating retirement, or anywhere in between, A Random Walk Down Wall Street is the best investment guide money can buy. In this new edition, Burton G. Malkiel shares authoritative insights spanning the full range of investment opportunities—including valuable new material on cryptocurrencies like bitcoin, and “tax-loss harvesting”—to help you chart a calm course through the turbulent waters of today’s financial markets.

How Stocks and Bonds Are Valued

Similar ideas to How Stocks and Bonds Are Valued

Initial rate of return and relative value of government bonds

Growth-rate to PE ratio