Editor’s note: This article was first published in March 2013. The market commentary is from March 2013: recent results from Inditex and Telefónica, Bankia trading far below its listing price, the 10 billion euro Cyprus bailout, and the possibility of the S&P 500 passing 2,000 points and the IBEX 35 rising to 9,000.
More and more people want to get into the stock market after hearing that you can make a lot of money there (and lose it too). Some will have heard that it is like the lottery, a matter of luck. I disagree, because in the stock market there are people who always win, which does not happen in the lottery. Well-managed stock investing is without doubt the most profitable investment, ahead of term deposits, government bonds and pension plans. Nor is it true that you have to be a financial genius to make money on the stock market. (Read: Warren Buffett: you don’t need a high IQ to get rich.)
Today we are going to set out five questions that anyone who wants to invest in equities should ask themselves, specifically when buying shares. At the very least, I always advise people to ask them.
1. Do I know what I am doing and what I am getting into?
We need a minimum of knowledge about the markets, and also about how the trading platform we are going to use works. For example, if you do not know the types of buy orders that exist, do not place a buy order.
Between sending a “market” or “at best” order and using a “limit” order, at certain moments the difference can be more than 1% that we miss out on. With some thinly traded stocks it may be even more at times.
2. What is my investment strategy?
Have you thought about what you would do if the stock you buy lost 10% the day after you invested? And if, after losing 10%, it opened the next morning down another 5%? I went in thinking long term, but do I have the stomach to watch my money shrink by 25% or even 50%? That brings us to the next point: what will I do if the stock gains 10%? Will I sell, or hold on despite the risk of a correction? Basically, it is about drawing up a strategy based on our risk profile. Before investing in a company we should work through every possible scenario (the negative and the positive) so that, when the time comes, we know whether we want to cut our losses if the stock falls 5%, or whether, on the contrary, we are hoping it falls 25% so we can buy more, and more cheaply.
3. Why am I investing in this company?
Most private investors make their first investment in a company someone advised them about, that they heard about, or that an analyst recommended based on technical analysis or its current fundamentals.
When we invest in the stock market we can take different expert opinions into account, but we are the ones putting our money on the line, so we are the ones who have to analyse the reasons for buying.
You can get someone’s advice for free, but if there are losses, they are yours, not the adviser’s. What I mean is that for your first investment you should not simply do what I say, or what anyone else says (even if you take our advice into account). If you do not really know how to read or interpret a company’s accounts, it may not be a good idea to invest in that company (or any other) for the long term.
An example: we recently saw the results of Inditex and Telefónica. Personally, I did not like Telefónica’s results, but the analysts did, so Telefónica is rising. I liked Inditex’s results, but the analysts did not, so Inditex fell on the stock market. That is the short term; in the long term Inditex has far more potential than Telefónica, although I would not buy Inditex above €100, but I would consider it if it had a sharp correction. Telefónica I might take advantage of in the short term, but I would not put it in my long-term portfolio. I may be wrong, but the rest of the analysts could be wrong too. So the final word before investing is yours, and you must be able to draw your own well-founded conclusions, whatever the analysts say.
To take just one example, one of the analysts’ top buy recommendations was Pescanova, even the day before it declared bankruptcy.
4. Can I afford to lose part or all of the money I invest?
I have always said that if an investment is going to keep you awake at night, do not even think about making it: there are enough things that can keep us awake without adding another. If we invest in the stock market, it is not to try our luck but to multiply our savings.
We should invest money we are not going to need and can certainly afford to lose. Any investor can get a nasty surprise at some point. An airline can crash three planes, an oil company can fall victim to an expropriation, or a company can get into serious trouble and fail to recover, and one morning you can wake up to find its shares suspended without warning. Even though the chances of this happening are very low if we have chosen a company well, there is always a small chance of it when investing in shares.
So if it does happen, how will it change my life? Could I cope, or would it push me to despair?
On the other hand, even if we draw up a ten-year investment strategy, when the time comes we may find there has been a war or that the European Union has gone down the drain. These are situations that make stock markets tremble and that are beyond our control. If you invest in shares, you should know this could happen; although, we insist, the chances are low, you always have to keep it in mind.
5. Do I know what moment I am investing in?
The IBEX is cheap. Buy! The S&P 500 is on a strong bull run. Buy!
The truth is that the IBEX is one of the cheapest indices and, supposedly, one with the most growth potential if we compare pre-crisis prices with current ones. But Bankia is also very cheap compared with its initial share price, and I would not buy it. Two weeks ago all of Europe’s problems were supposedly priced into the market, and now along comes Cyprus with a €10 billion bailout and has us all trembling. What will happen when they start attacking France?
As for the S&P 500, it could correct or it could pass 2,000 points; nobody knows. During the 1990s the Dow Jones rose by almost 1,000 points every year while the market waited for a correction that never came.
Perhaps my current advice is the same rule I apply to myself right now: I do not buy in an overbought market like the S&P 500 and the Dow Jones, and I do not buy in a market with as much uncertainty as the IBEX 35, where it could just as well correct now, then rise to 9,000 points and then correct even harder.
Of course, my motto is: “Better to be wrong and not make money than to be wrong and lose it.” That does not mean I have no positions in certain companies, but for now, no blue chips. So, do you know what point in the economic cycle we are at? Have you considered things the markets might not have priced in? I know it is a very complex analysis that even the best analysts get wrong, and I insist that nobody knows exactly what the markets will do. That is why, very often, the best indicator is your own common sense. Use it before you invest.
The good thing about this crisis for those starting out in investing is that at least we have learned that when everyone advises you to buy, it may be time to sell, and vice versa. Of course, right now, and specifically with the IBEX 35 at its current price, a long position carries the same danger as a short one. The index could head in any direction, and nobody knows which one is the winning horse.
Further reading
- The most profitable IPOs to date
- Warren Buffett’s best investing tips
- Five steps to build a dividend investing strategy
Featured image: Tomás Rodríguez Ontiveros, CC BY-SA 2.5, via Wikimedia Commons.
