Investing Basics

Investing is the act delaying the use of current purchasing power with the expectation of retaining a proportionally higher purchasing power in the future. It’s as simple as that. In other words, investing is an antonym of spending.

Warren Buffett, in his Letter to Berkshire Hathaway Shareholders in 1980, gives the following explanation:

For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.

As such, the most important thing in investing, as Buffett so eloquently describes in his short explanation above, is what economists call the Real Return.

Real Returns

The real rate of return of an investment is annual percentage net profit that it delivers on the capital invested, adjusted for changes in prices due to inflation. This effectively means that will yield 5% in one year, will have a 0% return if the inflation rate is 5%.

The calculation of yields and returns of investment is a subject in and of itself. The comparison of bond yields, for example, is a surprisingly tricky subject. In order to compare two bonds on a like for like basis, an analyst would need to take into account factors such as the duration of the bonds, the coupon payments and interest rate.

Before the advent of computers, bond analysts would use so-called yield books, to compare different fixed income securities. The brown books would include price-to-yield tables that would aid the analysts in comparing different bond yields on a like-for-like basis. In 1974, Marting Liebowitz and Sidney Homer published a seminal book named Inside the Yield Book: New Tools for Bond Market Strategy.

The book drew on the research and models that authors had worked on and been publishing to within the bond trading community for several years. A crucial concept in the book was the concept of Interest on Interest. Leibowitz and Homer argued that the then prevailing price-to-yield tables had a blind spot for the interest that could be collected if interest payments were reinvesting and held until the bond was sold or it matured.

Compound Interest

Although the concept of Interest on Interest was new in the context of bond investing, the theory of Compound Interest has existed for a long time. The Wheat and the Chessboard Story is a famous mathematical problem that which earliest published record is in the work of Ibn Khallikan, a 13th-century Islamic scholar and judge.

According to the story, a wise man by the name of Sissa ibn Dahir, invest the game of chess to show the tyrant Indian king Shihram that he needed all his subjects and that he should take good care of them. The King is really impressed and asks Sissa what he would like in reward. Sissa proposes that the king put one grain of wheat on the first square of a chessboard and then double the number of grains of wheat with each square until all squares of the board have been covered.

The King mockingly accepts, thinking that he would have accepted a much bigger reward had Sissa asked for it. However, at the 34th square, the number of wheat required was more than 4 billion grains. In fact, to finish the chessboard would have required six times the weight of all living things on earth by some estimates.

Compound interest is important in the context of investing, as it demonstrates that due to the interest on interest, even relatively small returns will become a large number over a long period of time.

When Jeff Bezos asked Warren Buffett, even his investment thesis is so simple and the fact that he is one of the richest men in the world, why everyone doesn’t just copy him, Buffett replied: “Because nobody wants to get rich slow.”

Return of Capital

Before you have a return on capital, first you have to have a return of capital” is a phrase often used by people in the finance industry to illustrate the importance of downside protection and protecting yourself from the risk of losing money. But what exactly is Risk?

Although Risk Management is a central topic for most investment professionals, how risk is defined within the finance industry can differ drastically. The following is an overview of 3 different frameworks of risk management within the finance community.

1. Efficient Markets and CAPM

The Capital Asset Pricing Model (CAPM) is a widely used formula in finance, which has been in use as a framework for asset pricing and portfolio evaluation for over 50 years. It describes the relationship between systematic risk and expected return for stocks and is often used when calculating a company’s Cost of Capital. CAPM is a subset of the Efficient Market Hypothesis (EMT) and Modern Portfolio Theory (MPT), which argue that markets are efficient and stock prices instantaneously reflect all publicly available information at any given time.

In the Capital Asset Pricing Model, Risk is defined as the difference in the price movement of the investment in comparison to the general market. This measurement of volatility is called Beta in the CAPM. A stock that is more volatile than the market will have a Beta greater than 1 and thus add risk to a portfolio. A stock that has a Beta of less than one will reduce the risk in a portfolio, according to the formula.

2. Downside Risk

The theory of downside risk states that when considering an investment, the primary question an investor should ask himself is how much capital would be lost permanently in an adverse scenario.

In this context, the word permanently is the operative word, as an analyst estimating downside risk does not take price fluctuations into account. The loss is only permanent when it is realized when the security is sold or if there is a permanent impairment it the value of the underlying assets.

Downside Risk is one of three central concepts in the methodology of Value Investors, along with Intrinsic Value and Mr Market. Most commonly referred to as the Margin of Safety, the concept requires the investor to form an opinion on what the Intrinsic Value of the underlying assets of the security is. If the market price of the security is trading at a discount to the Intrinsic Value, the discount represents the Margin of Safety.

The late Walter Schloss, one of the early disciples of Value Investing, is known to have said: “I learned that if I can simply survive in the market, just like surviving in the war, and not lose money, eventually I will make something.”

The focus on not losing money derived from a very simple fact: Earning back previous losses is hard. Really hard. From a mathematical perspective, a portfolio that drops 33% in value, needs to appreciate by 50% just to break even.

3. Risks with Adjectives

For anyone conducting Fundamental Research, term Risk is meaningless unless there is an adjective in front of it. In his book, Modern Security Analysis, Martin Whitman list up the most common risks that an analyst would consider while researching a company:

  • Market Risk: The risk of losses due to adverse movement in market prices of an investment.
  • Investment Risk: The risk of permanent impairment of a security’s underlying assets.
  • Solvency Risk: The risk of a company being able to operate profitably.
  • Liquidity Risk: The risk of a company defaulting on payments of its liabilities due to lack of current assets.
  • Commodities Risk: The risk of the cost of commodities required by a business affecting the profitability of the company.
  • Country Risk: The risk of adverse changes the economic or political environment in a given country that a company operates in or that securities have exposure to.
  • Currency Risk: The risk of devaluation of currency that a company or a security is exposed to.
  • Inflation Risk: The risk of inflation hurting the real return of an investment.

The Risks with Adjectives theory, as well as the Margin of Safety theory, reject the proposition of the Efficient Markets Theory, that in order to get higher returns, one must take more risks. Alternatively, both these theories propose that in order to get higher returns over the long terms, one must take fewer risks.

Passive vs Active Investing

There are generally said to be two main types of investing, active and passive. For passive investing, the aim of the investor is to achieve the returns of the market or a specific market benchmark. In Active Investing, the investor is aiming to outperform the market or the market benchmark.

In an actively managed investment fund, an investment manager makes decisions on how to allocate the funds resources, based on internal research. A passively managed fund, contrastingly, has the aim of to deviate as little as possible from a market index or benchmark. Therefore, as an index fund merely imitates the benchmark, it does not require in-house research and has a leaner cost structure.