Dear daughter,
After reading many books, watching many videos, participating in webinars, reading everything that comes close to me about investing in the stock market, and investing for a few years in the stock market, I can tell you that investing in the stock market is about answering three questions:
- What to buy in the stock market?
- When to buy in the stock market?
- When to sell in the stock market?
Once you have the answer to those three questions, you are ready to go.
Before going into the details of the questions, let me clarify something.
When you hear from someone, I bought a company in the stock market, they usually mean they bought shares of a company in the stock market.
How does it work?
Let’s say a company is worth $100 and there are 10 shares, then each share cost $10.
So, when people say I bought company X in the stock market they mean I bought N shares of the company X in the stock market.
When you buy shares, you are entitled to a portion of the company’s profit. The portion you are entitled to, is proportional to the number of shares you own. If there are 10 outstanding shares and you own 5 shares, you are the proud owner of 50% of the company, and you are entitled to 50% of the company profits.
Investors also refer to company shares as stock. You will hear I bought/own/sold Company X stocks.
1. What to buy in the stock market?
This is the first question you need to answer yourself.
If you want to know what to buy, or what business you will prefer to buy, you need to study the business.
Never ever buy a business because someone told you is a good business to buy.
You will want to buy a business because you understand the business. You know is profitable and you can think that it will be around for a long time.
For you to understand a business, you need to be able to interpret financial statements. As I mentioned in my previous letter “So, here is where you start. Learning accounting and especially learning how to read and interpret financial statements.”
From the financial statements, you will learn most of what you need to know about a business.
How do you identify a business, so you study it and then understand if you want to buy it or not?
Some people call this a “business idea”.
You have several ways of doing this.
The one I like more is by looking at the products I like.
For instance, I like Apple devices (iPhone, iPad, MacBook), they are great and durable (although programmed obsolescence is real).
So, I can study the Apple business, so I understand more about it.
Remember what I told you in many of my letters about making a financial decision?
Every time you must make a financial decision, look at the numbers. Only the numbers will tell you the truth.
In investing, this is especially true.
If after you study the company, the numbers look good, then you move to the next step.
You need to find out if the company has a durable advantage in respect of the competitors.
These can be done in different ways and there is no one solution to get the answer.
To keep with the same example, you can ask people you know that use Apple products, if they are satisfied, if they will buy the new product as soon as they can or if they will change to another brand.
You can also look into the financial statements to answer this question. What happens when a new product goes the first time to the market? Does the profit go up? Are the new units sold as expected?
There is a lot more to analyzing a company. However, I don’t want to make it too long because I don’t want to overwhelm you with a lot of ifs. Also, when you spend too much time on something you can fall into the analysis-paralysis. You spend so much time analyzing that in the end, you do nothing. That is not a place you want to be and definitely a place I don’t want you to be.
Lastly, I want you to answer this question:
- Will I lose my money if I put it into that company?
This is the most important rule of investing: never lose money.
Warren buffet will say he has only two investing rules:
- Never lose money.
- Remember rule #1.
That’s it.
Now you know what company you want to buy, it is time to answer the second question, when to buy?
2. When to buy in the stock market?
This work in the same way as when you want something, but you don’t buy it because is expensive at the time.
You can look at a business like a product.
Is it worth paying that price for that business?
This is a question with different answers for different people. For instance, some people will never buy an Apple device because, for them, it is too expensive. Others will buy anything because they like the product and think it is worth the price.
The same applies to businesses. You must make a valuation of the business, so you have an idea of how much is worth that business to you.
There are many ways of doing a business valuation. The one I like the most is the Discounted Cash Flow (DCF) method.
Warren Buffet says that when he buys a business, he just needs to know, or estimate, how much money he can take out of that business in a certain period. If after the estimation, the numbers look good, then he knows is a good business to buy and the price that he wants to pay for it.
Regarding the price, people have many rules. A common one that you can apply is always buying at a discount. Investors also refer to this as the margin of safety.
Let’s say after you do an estimation of the value of the company, the result shows that 1 share of the company is worth $100 to you.
If you decide to buy at a $10 discount, then you will only buy when the share price is $90.
The advantage of doing it like that is that when the company’s share price has the fair price (the one you calculated), you will already have a 10% return on the investment. This usually happens without the company increasing its revenue or getting a new product to the market.
The value you calculated, is your own estimation. Someone else will probably make a different estimation. That is why most of the time there will be a buyer willing to buy and a seller willing to sell in the stock market.
Now, let’s jump to the next and last question.
3. When to sell in the stock market?
To know the answer to this question is as important as the two previous answers: what to buy and when to buy?
Why?
Because you bought a company according to your estimations, and nothing is written in stone. A company can go bankrupt because of different things, or you can just make a mistake in your estimations.
When you invest, you will sometimes make mistakes. Then, you must cut your losses short.
Guess what will happen if you buy a company because I told you it was a good company to buy.
You won’t be able to know when to sell it. You will have to ask me. You don’t want to do that as much as I don’t want you to do it.
However, if you studied the company on your own and you understand it, it will be easy for you to answer this question.
You know why the company is good. So, if what was good in the company changes (and sometimes it does change) then you know it’s time to sell.
Sometimes people get sentimental about selling. You can say, but maybe the company will get better, maybe new management will be appointed, or/and the problems will be corrected. None of it is worth keeping yourself from selling.
What you do is you sell, so you don’t lose (more?) money (remember the first rule of investing). If after a time you see that the problems are fixed, and you understand the company is still a good buying prospectus, then at that time you can buy it again.
As some investors say, the stock doesn’t know you, it doesn’t know you own it, so don’t get sentimental about selling it.
Dear daughter, I want you to understand that the purpose of this letter is to give you the big picture of what investing in the stock market is. It is not a step-by-step guide for you to start investing in the stock market.
Before you start investing, you should study, learn as much as you can, and only when you feel comfortable you can make your move.
If you feel that you know everything there is to know about investing in the stock market, that is a good sign you need to study more. Don’t invest yet, keep studying.
Love you, Dad.