What does it mean to make the stock market winnable?
I like this phrase because I think it represents the mindset of a value investor. I like to think of winning in the stock market as mostly a temperamental and psychological game. With this in mind, developing a set of rules or principles can help keep you on track.
Most of the principles I’ve narrowed down and focused on are from Warren Buffett and Ben Grahams teachings.
With that said, too often investors like to put emphasis on what the stock market appears to be doing. One of the best teachings in value investing comes from Ben Graham. He teaches us about what he called “Mr. Market”. Mr. Market (the stock market) tends to have emotional swings. This is because the market is run by humans and humans tend to be irrational from time to time.
Another way of contemplating Grahams teaching is by thinking of it as exploiting human emotion. That is what is really happening when we profit in the stock market. Only when we take advantage of other peoples irrational buying and selling can we profit as a value investor.
Instead of putting emphasis on what we think the market will do, we should focus on what we can control.
In other words, instead of thinking about the market at all, we should focus on that individual business we are investing in.
Here are what I believe to be the top 5 principles a value investor should have to make the stock market winnable:
- Have patience
- Limit the downside
- Have a margin of safety
- Have a level of competence
- When you bet, bet big
- Have patience
According to Investopedia.com, “Patience and discipline is a virtue that will benefit all traders, keeping emotion and snap judgments in check”. Having patience is the key to successful investing. It’s as simple as that.
There have been numerous studies done on this topic. Most say something along the lines of how it’s better to be a long term investor than a short term speculator. That’s because a long term investor knows it’s impossible to know what the market is going to do.
However, an investor can also look at a business and rationally determine what it could look like in 10 years. Maybe not all businesses, but there are some where this is possible. That is because we can use quantitative and qualitative facts to help us come to a decision. At the same time, no one can predict what the overall market will do today, tomorrow or next month.
Having patience will allow you to see the true value of a company over the long term.
2. Limit the downside
What does it mean to limit the downside?
To answer this question you might ask yourself, what risks am I actually taking?
One of my favorite principles I’ve learned when it comes to investing and making the stock market winnable is something called taking asymmetrical risks. This principle comes from a book written by Karen Finerman: Finerman’s Rules: Secrets I’d Only Tell My Daughters About Business and Life. In this book, Karen describes that this means an investment may have limited downside but huge upset potential.
I like to think of this by asking myself a question. How likely can you guarantee that a business you are investing in will be here in the future? Be honest with yourself.
If you have no facts that can help guarantee this, then the downside potential of an investment may be larger than you think.
I believe this is another way of describing our next principle, #3: Have a margin of safety.
3. Have a margin of safety
Having a margin of safety could arguable be the most important principle on this list.
Stemming from the works of Benjamin Graham, he taught this principle to Warren Buffett while he was his student. If you study just a fraction of what Buffett has done, it’s obvious that this methodology works.
The principle suggests that an investor should buy an investment only when it can be below its intrinsic value. Warren Buffett would define intrinsic value as all the cash that can be taken out of a business in its remaining years. This is where the concept of valuing a business begins.
I believe this should be a starting point for any investment because the goal of an investment is to make money. Shouldn’t that mean that any investment we make in a business be in one that makes money as well?
Therefore, a company that makes a lot of money is more valuable than a business that doesn’t.
If you can buy a company that is cheaper than it should be valued, you may be well on track to making the stock market winnable.
In other words, buying a great investment is not just about finding the right one, but finding the right price to pay for it.
4. Have a level of competence
What is competence?
Competence means having the knowledge of something that makes you qualified in that subject.
Another question you might ask yourself to make the stock market winnable is, “do I know what I’m investing in?” If you cannot tell your friends and family what product is made or what the company does, then you may not want to invest in that stock.
It is very important when making an investment to think about the asset. Try to understand as many facts as you can about it. An investor should be able to identify some kind of competitive advantage that this company has. What is it about this company that makes it hard for competitors to steal an idea or make a similar product?
Buffett and Graham would explain this concept by describing a business with a moat. The larger the moat a company has, the harder it is for anyone to steal market share.
5. When you bet, bet big
Warren Buffett likes to use the analogy of baseball to describe making the stock market winnable.
In a nutshell, he describes buying stocks like any great hitter plays the game. Instead of swinging at every pitch, you wait until the perfect ball comes down the middle of the plate. These are the players that usually have the best batting percentage.
This also means you don’t have to be invested in 25 stocks to make the stock market winnable. Only selecting a few at a time can build wealth.
As you can see from the photo below taken from CNBC.com, Buffett has over 70% of his wealth in only 5 stocks as of March 22, 2022.
The key to this however is that when you do find that one stock, you must invest an amount that can have an impact when it starts to appreciate.
While following one of theses principles may not make the stock market winnable, I believe that following all of them can guarantee that anyone will build wealth in individual stocks over a lifetime.
What principles or rules do you follow when it comes to investing?
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