To bake a cake, you need the right ingredients. If don’t have good flour, the right kind of sugar, and fresh eggs, you might still get lucky and bake something tasty. But chances are, without these critical ingredients, your cake won’t taste like cake.
It’s the same thing when it comes to analysing investments – whether it’s real estate, stocks, funds or crytpocurrencies. Bad ingredients leads to a bad result.
I’d point to these four things… the good-cake ingredients of a good investment. Tell me if you disagree, or think I’m missing something.
1. You need context… and experience matters
What’s the first thing you ask when your kid comes running up to you, telling you that your other kid just hit him? You ask for context. Well, what happened? Who hit who first? Why? When? You don’t take anything at face value.
It’s the same with investing: Context matters. Who are you buying it from? Are you the greater fool? Why is it for sale? What’s the reason for it being cheap/expensive? (Cheap stocks are often cheap for a reason… and can always get cheaper.) And why do you think you know something that the seller doesn’t – if it was such a great investment, he wouldn’t be selling it, would he?
Answering these kinds of questions isn’t easy. You can do it on your own – just like if you’re sick, you can research your ailment on the internet (headache=brain tumour, anyone?) and self-medicate (Scotch on the rocks, anyone?).
Or, you can talk to someone who’s done it all before, and who knows what to look for, and what works and what doesn’t work. So if you’re new at real estate, it helps to talk to someone who’s been doing it for a long time. And if you’re curious about cryptocurrencies, you can listen to people who tell you to buy a few dozen cryptocurrencies and hope for the best… or who apply stock valuation methodologies to cryptocurrencies (spoiler: bad idea).
Better: You can follow the insight of someone who has real-life experience in the world of cryptocurrencies and has the insight and know-how to separate the good from the bad.
In any case, context is critical – and experience matters when you’re figuring that out.
2. What are the other options?
There are an infinite number of things that we could buy. But we don’t have an infinite amount of money (unfortunately). So whenever we buy one thing, we’re making an explicit decision to not buy many other things. And there is a cost associated with that decision – it’s called the opportunity cost.
When you’re investing in stocks, the opportunity cost is easy to figure out. You can see how other stock prices changed after you made an investment decision, and (if you want to torture yourself) look at how much money you might have made.
But the “cost” of what you didn’t buy is less clear with respect to other types of goods. The money you spend on that long weekend at the beach is cash that you’re not putting away for your children’s education. You’re also not buying shares in a stock that could double or triple next year (or in a stock that could fall to zero).
Part of assessing an investment is looking at the other things that you could be buying. Opportunity cost is a part of any investment decision.
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3. Price is important
The shares of a great company that are expensive – that is, they trade at a high valuation (such as the price-to-earnings (P/E) ratio) – may be a lousy investment. And the stock of a terrible company – if it’s cheap and things are beginning to improve – might be a fantastic investment. If your objective is to make money – and if you’re reading this I’m guessing it is – then the price you pay, more than anything else, will determine whether or not you wind up making, or losing, money.
Study upon study has shown that cheap beats expensive when it comes to profiting from markets. One of the best ways of measuring value in stock markets is to use the cyclically-adjusted price-to-earnings (or CAPE) ratio, which smooths out short-term price fluctuations.
Investing in markets that have a low CAPE, on average, results in much better returns than buying stock markets with high CAPEs. Of course, this is the same for stocks… all else being equal, your odds of making money improve when you buy a stock that’s cheap, rather than a stock that’s expensive.
In the short term, anything can happen to the price of an asset. More people rushing in to buy an already-expensive “hot” stock will push the price up higher. And negative sentiment towards an out-of-favour market or stock can mean that it takes a while for a cheap asset to rise in price. But in the end, price will prevail.
4. You can’t skip the research
You can’t fully understand the context (see point #1 above) or know if something is cheap or not (see point #3 above) or know your other options (see point #2 above) if you don’t do the work to figure it out… or if you don’t have someone both knowledgeable and trusted to help you.
For some people, that’s a financial advisor. I believe that with some time, energy and focus – far less than you might imagine – everyone can become masters of their own financial universe (that’s one of the main reasons Stansberry Churchouse Research exists).
Of course, you can get away with being lucky… for a while. Eventually, the odds catch up with you, though.
Bonus: Once you’ve invested…
So you understand the context… assess the opportunity cost… and you’re buying on the cheap… all after doing the required due diligence.
But despite it all, an investment isn’t working out. And so, you need to act before those losses affect your entire portfolio.
Part of this is ensuring that you exercise smart risk management practices (with stop-loss levels, for example). And diversification – or macro-versification, as I call it – is central to understanding your opportunity cost. Position sizing is important too… and you shouldn’t invest more than you can afford to lose in even the most attractive, can’t-miss, grand-slam speculative investment opportunity.
My friend and colleague Tama Churchouse, in our new crytpocurrency publication Crypto Capital, advocates a ceiling of only 5 percent of your investment portfolio in cyrptocurrencies at an absolute maximum– and that’s only if you are maximum bullish and really know what you’re doing… even if the upside potential is extraordinary.
Publisher, Stansberry Churchouse Research