If buying a stock were a sure thing, you wouldn’t see the 50-100% returns that are common from individual stock investments. Taking risks is what allows you to make more money investing in stocks than you could earn from a bank account. The auction system causes stocks to be priced such that when things go well, you can make a large return.
But that also means that things will not always work out. In fact, they don’t work out so often with individual stocks that while you can get 100% or even 1000% returns within a year or two from a great buy, the average return for a portfolio of stocks like an index is in the range of 10% per year over long periods of time. This means that for every stellar performer that returns 100%, there are around ten that go up less than 10%. Some even go down in price, sometimes to zero.
There are two methods often used to reduce your risk when investing. The first is commonly talked about: Diversification. This is where you spread your money around to many different stocks. Here, you’re accepting that you’ll make around 10% instead of 100%, but at least you probably won’t lose money. The second method is what we’ll discuss today: using time.
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Stock discount pricing
While people often forget it, stock pricing ultimately comes down to dividends. Because growing earnings usually result in growing dividends — even if the stock pays no dividend right now — stocks that see earning growth usually go up in share price. Think about it: If a stock pays out $1.00 per year per share in dividends, you can get a 20% return per year if you pay $5 per share. This assumes that the stock actually pays out the $1.00 per share, meaning the company makes enough money to pay that dividend.
If the stock is very likely to pay out that $1.00 dividend you probably aren’t going to get it for $5 per share, however, unless interest rates are so high that bank CDs are paying out 10% or more. This is because if you buy it at $10 per share, you’re still getting a 10% return, which is way better than the 1%-3% you can usually get from bank CDs. Even paying $20 per share would give you 5%, which is better than the bank rates. If you are nearly certain the company will pay the $1.00 dividend, buying the stock instead of leaving your money in the bank would be a no-brainer.
But if the company might pay it or might not, you’d want a bigger payout. You probably wouldn’t do it for a 5% return if the odds were 50-50, but you might if you were getting 10% or 20%. You therefore would buy the stock for $10 or $5, but not for $20. This is called “discount pricing.”
Because you are putting your money at risk, the price you pay for shares of a stock should be reduced (or discounted in accountant speak) from the price they would be at if you were assured that the company would make the earnings expected and pay those earnings out in a dividend. This means you need to consider your risk when buying a stock and come up with a price where you will be properly rewarded for taking the risk. Just as in real-estate, the profit is made when you buy with the price you pay, not when you sell. But how do you figure out a good price?
Auction Markets
Luckily, with the market-based system you don’t need to figure out the right price to pay to get an appropriate risk premium. Smart people with sophisticated computer programs do that for you by buying shares if they are cheap and selling shares if they are expensive. The auction systems use are constantly adjusting the price for perceived risks. As a result, the price of a stock will generally, but not always, already contain an appropriate discount for the amount of risk you are taking.
To improve your chances of getting a good price, you can also follow the share prices for a few weeks before you make a purchase and try to buy when the stock is it the low end of the range. This can be done easily by placing a limit order, where you set the maximum price you are willing to pay for a stock. You can also look at the price-earnings ratio, or PE, or the price to sales ratio, or PS, and only buy stocks that are at or below their average PE or PS level, averaged over the last several years.
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The emotional price
So far, we’ve been discussing pricing based on expected returns. If everything were perfect, this is the price a stock would trade at all of the time. But this is not the case. Beyond the pricing based on value and expected earnings, called the intrinsic price of a stock, are random fluctuations based on what the markets are doing, world events, and even market manipulation. People get emotional and dump shares when they get worried and pay way too much for shares when they get greedy. This is called the emotional price and can be every bit as big as the intrinsic price sometimes.
The more volatile the investment you’re making is, the less able you are able to predict future values. If I put $1000 in the bank in a CD paying 5% per year, I can predict with almost certainty that I will have $1050 in a year. If I put $1000 in a stock that I think has the potential to grow earnings by about 15% per year, I have no clue what the price of the stock will be in a year. I might have $2000. I might have $500. All that I know for sure is that I’ll lose $50 or so immediately due to transaction costs and brokerage fees.
The company I invest in may have a bad quarter, miss earnings estimates, and fall 20%. The economy in general may run in troubles and the stock price may fall. A competitor in the same industry as the stock you purchased may run into trouble and people may sell stocks in the whole industry. The company may even post record earnings, but those earnings may be less than the “whisper numbers” some people may be expecting, and the price of the stock may fall.
While it is hard to time when the price of a company may go up, it is reasonable to expect that the stock of companies that are run well and are growing will increase in price at a rate about equal to the growth rate of their earnings. This will be in fits and starts, with some declines or even crashes along the way, but over long periods of time you should be able to get a fairly predictable rate of return. It might be that the stock doubles the first year and then trades within a range over the next few years, it might be that the stock price increases steadily each year, or it might be that it goes nowhere for several years and then doubles in price. What can be done about this?
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Put time on your side
Many people will buy great stocks, but then random events and emotions will cause the stock to not perform. The stock really should be priced at $50 per share, but because Russia invades Ukraine, people get scared and drive the price down to $20. What do you do to counter this risk caused by the emotional price? The answer is to simply only buy stocks if you are planning to invest for a long period of time. These fluctuations will not last and eventually the stock will be priced at (or above) the intrinsic price. Luckily with stock investing, you can just buy and hold. You can just wait for emotions to change and your stock’s true value to be realized.
For mutual funds, I’d be reluctant to invest unless I was planning to invest for at least five years and maybe ten years or longer. For individual stocks I’d probably be looking at ten years or more. This gives time for the company to grow and people to realize that it is a great company and bid up their stock price. I don’t have to guess what will happen with the economy, people’s emotions, or understand what trading strategies people are employing will do to the price over any given period. I just know that if I wait long enough, things should work out and I should get the return needed to justify the risk I am taking.
I therefore would use the following guidelines:
1. For cash needed within six months, use a bank account.
2. For cash needed in one to three years, invest in bank CDs or perhaps high quality bonds set to be redeemed within the period.
3. For cash not needed for five to ten years, split the money between stocks, bonds, and cash, and use mutual funds to diversify.
4. For cash not needed for a decade or more, invest in stocks through mutual funds and select individual stocks.
By using time to put the odds in your favor, you can get greater returns by collecting the risk premium.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
