Truths of Investing

When to start investing

Truths of Investing

Many people want to start investing and building their wealth but somehow, they are still waiting for something. Maybe a bigger salary, maybe when they get older, they would get more knowledge and can invest most successfully. But there is no need to wait and while you wait you can miss out on big gains and returns. The time to invest is now, the younger you start to invest the bigger your successes will be.

The earlier you start investing, even in small amounts, the faster you will accumulate a significant amount than if you start later with larger amounts. This is true assuming that investments are made periodically and without interruption. The assumption is also based on the principle of average returns.

The earlier you start investing, the more capital you will accumulate, even if you do so with smaller amounts than if you start saving and investing later. In the following example, there are two investors: Marley and Beatrix. Marley starts earlier by allocating $5 000 each year, and Beatrix starts later by allocating $10 000 each year. Each earns the same annual compounded return of 7%. Marley invests $200 000 over his 40-year investment period, while Beatrix invests $300 000 over 30 years. You can see the final result in the figure below:

Marley has saved more money in the form of investments, although he has invested less because he started much earlier. This is known as cumulative returns.

Since we have already established that you need to start investing as early as possible, which investments should you choose according to your age? This is the subject of the following illustration, which shows statistics for a period of more than 40 years.

The older the investor, the more his capital allocation should move to the left (top of the allocation picture), where there is less volatility, as there is less and less time left until retirement when the accumulated capital will be used. Older people should not risk their accumulated wealth and opt for safer investments such as government bonds. The younger the investor, the more aggressive the investment strategy and capital allocation should be and the more aggressive the return should be, as there is still plenty of time before old age and the investor can weather one or even several market downturns.

Truths of Investing

Time to Invest

Truths of Investing

We have talked several times about the right time to invest and about trying to invest when the price has bottomed out. We have also talked about a time-tested and affordable strategy, which is to reduce the average price by making trades periodically.

Let’s try to look at cases where a single amount is invested and what can happen when the investment is made at the wrong time, for example at the top of a market index.

The illustration shows that from the peak in 2000 to 2014, the market price of the index has remained unchanged. If you had invested in the index in 2000, you would not have earned any capital for 14 years. It is worth noting that during this period the stocks in the index paid dividends, whereas the example is only about the return on capital.

By contrast, if the investor had adapted to market changes and managed his investment portfolio dynamically, he would also have earned from a fall in the market or a reduction in the average price.

If you are a very long-term investor and are saving for retirement, your goal is in the long term and dynamic investment management will probably not be very relevant, because in the long term, investments in securities provide positive returns.

Why? It’s all proven by statistical calculations based on historical data. Also, the Internet is full of stories of individuals who have invested a few hundred dollars in one company or another and have become millionaires in old age. Although the purchasing power of a few hundred dollars 80 years ago was twenty times greater, the capital gains over such a long period are still incredible.

As you can see from the illustration, the shorter the investment period, the greater the amplitude of fluctuations. As the time horizon increases, the return-risk ratio statistically improves and the risk of losing capital is gradually minimised.

Of course, not all investors will want to follow such a strategy and there will be people who are willing to take more risks. It is precisely this type of investor who will tend to chase the bottom and actively enter and exit positions.

Truths of Investing

Price/earnings ratio

Truths of Investing

Some investors use the P/E (Price/Earnings Ratio) to check whether a share is overvalued or not. Although many people think that companies with a high P/E ratio (20+) are not worth investing in, this is certainly not true. It is widely accepted that a low P/E is below 10-12.

A rising P/E ratio reflects investors’ expectations about the future of a company. If the P/E is high, market participants believe that the company will live up to expectations, which is why it is worth paying a significant premium for the earnings per share (EPS) it generates. If the P/E is low, no one expects a good future.

Some brief examples:

Does a low P/E mean a good investment? Let’s look at Bed Bath and Beyond (BBBY). BBBY’s P/E ratio has been below 10 from 2016 to 2019. Does it look like an attractive investment? Here’s a historical graph of BBBY’s P/E ratio:

Source: WolframAlpha

Now let’s look at the price trend since 2016, when BBBY’s P/E ratio became very attractive and below 10.

Source: Portfoliovisualizer

We can clearly see that BBBY lost about 80% of its initial investment when the S&P500 more than doubled. Since BBBY has become a loss-making company, we no longer have P/E data.

Or maybe BBBY’s P/E ratio only became so low after this fall and now there is an investment opportunity? OK, let’s take that into account too.

Source: WolframAlpha

Is it a rule that a low P/E means a bad investment? NO. But it is worth thinking carefully about whether this low P/E ratio masks pessimism in the market about the future of this company. There are some companies that have a low P/E, whose share price has a lower growth rate than the indices, but which pay higher than average dividends. Good examples would be Ford Inc, AT&T Inc, Verizon etc.

On the other hand, let’s look at a high P/E ratio and how it can hide a company whose share has huge upside potential.

A very good example is Adobe Inc. (ADBE) company. A company that was growing rapidly and, during the correction of 2022, lost a lot of value. Let’s take the same comparative period as with BBBY, and see what the results would have been if we had invested in ADBE with a high P/E and held on to it until mid-2022.

Source: WolframAlpha

Source: Portfoliovisualizer

Your eyes do not deceive you. In 2016, this company’s P/E was just above 70. While the P/E has been gradually declining, the company’s share value has been growing at an incredible rate. Why? Because investor expectations were high for Adobe Inc. and market participants were willing to pay a fat premium for the opportunity to buy shares in this company. And their expectations were met – the company grew fast and increased its profitability.

Again, it is not a rule that a high P/E ratio always signals an opportunity to get rich. The main point of this article is that a low P/E and a good investment is a myth, just as a high P/E is a bad investment. The P/E reflects the expectations of the market, and whether or not these expectations are justified is a matter of a more detailed analysis.

Truths of Investing

Discipline and strategy

Truths of Investing

In investing, no one is 100% right. And you don’t have to be right all the time. There are investors who are only right 30% of the time, but they earn far more than the vast majority of market partici-pants. Discipline and an investment strategy are what it takes to make money. These elements are key even if your accuracy is low. analysis works. It really works. But I will not teach it. It is an art that everyone understands and applies in their own way. But you can be assured that it does work.

People lose money using technical analysis because they choose the wrong time period, Or rather too short of a time period.In short time periods, the price behaves chaotically and is difficult to read from the charts. Experience shows that over longer time periods, technical analysis gives more accu-rate signals (daily, weekly or monthly).Of course, you need a lot of patience for such long periods, but that is what investing is about.For the patient, the sky is the limit, for the undisciplined, losses will occur.

The following chart may be a bit old, but it illustrates this point very well – you don’t have to be right all the time in investing, but you do have to have discipline and follow a clear strategy.

You can see Lance Roberts’ comments on the price chart and moving averages in this image, but it would be useful for everyone to seek their own truth in it. 

The hardest part of investing is the psychology. It seems easy at first, but any practitioner can attest that psychology and discipline account for half the results. 

Many times you will see bigger or smaller price drops in the market. Sometimes a 4-5% sell-off can look like a new recession, so it is crucial to always keep an eye on longer-term charts and indicators. The following picture is a good illustration of negative and recessionary periods in the markets, and there are many of them.

Further to investor psychology, it is important to be able to filter the information that circulates in the public domain. You may have noticed that there are many people who start commenting on the financial markets without even understanding what it is or how it works. Novice investors have a fragile psychology and often fall victim to such unfiltered information. They lose their own opinions and start following the noise. 

It seems that as individuals we are looking for validation of our thoughts or ideas in order to feel more secure about our decisions. But it is always worth considering whether those sources of information are reliable. For example, do economists working in Lithuanian banks have a good understanding of Bitcoin? Certainly not. They work on the basis of theories and, as you know, their theories say nothing about a technological revolution like Bitcoin. But they still start commenting on things they do not understand at all. And of course, they are rarely right when they talk about things they do not understand. This is noise. You need to avoid the noise in order to be able to use your head and learn from your mistakes. 

The following illustration shows the emotional reactions of ignorant investors to market movements and their irrational decisions based on these emotions.

At the beginning of my journey as an investor, I saw this exact illustration and thought that you have to be stupid to play on emotions. But then I tried this thought experiment. Before every crisis, I would turn the chart of the S&P500 index so that it showed me a picture as if I did not know that a market crash was just around the corner. And I can tell you that I used to want to buy those charts. I wanted to buy every dip in the market, just as I had done before. And all the moving averages and price candles looked attractive. But it was a deception. This investment strategy would have driven me into bankruptcy. So when I realised that my own psychology was weak. Instead of looking at how to generate money, I evaluated how best to protect myself on the markets.

Truths of Investing

Market trends

Truths of Investing

Practice shows that it is wisest to invest and trade along the market trends. Most opportunities arise when the market is moving in a clear direction, and even if an investor has chosen not to include the best companies in his portfolio, he will still benefit from the overall market movement. 

It is useful for everyone to have their own method for determining the direction of the market. It is almost impossible for even professional investors to identify a change in market direction or a turning point, but each of us can have our own way of realising at the earliest possible moment that the market has changed direction and that there is a need to re-model our portfolio. 

In practice, moving averages are commonly used for this purpose. When the price crosses the moving average from above or below and the candle for the observation period closes below or above the moving average, a change in the direction of the price is indicated. This is what the theory says. But is this always the case? Again, each tool needs to be able to be applied and interpreted objectively. A lot depends on the period of the observed price or moving average. In order to identify changes in the long-term direction of the market, the author uses monthly and weekly price observation periods, as well as a number of moving averages and volatility, stop indicators. He also calculates mean reversion based on standard deviation. 

The most important thing is that each investor has to find the method and tools that are most convenient and suitable for him or her, and that will allow him or her to avoid major losses.

Since the largest daily changes (negative) in the market occur when the price is already below its long-term moving average, this indicator would help to avoid larger losses when panic among market participants gains momentum.

Following on from this, the second insight in this series of articles is that, once a change in the direction of the market has been indicated, it is important to draw the right conclusions in relation to one’s investments. 

The graph shows a study carried out by Javier Estrada, Professor of Finance, IESE Business School, University of Navarra, Spain

The graph shows what the results would be if an investor had no open positions on the ten worst days in the market (red curve), on the ten best days in the market (blue curve) and just always had open positions in the market (green curve). 

Timely indication of market direction and adapting to changes in conditions can lead to significantly better results in the long term. The more time an investor spends out of the market, he loses the opportunity to have invested his capital during the ten best days on the market (or at least one of them), and you can see the results on the graph for yourself in addition to these ten days. Also, a correct understanding of the indicators can help to avoid the ten (or one of them) worst days in the market and also to achieve extremely high results.