The most important thing for active, self-directed stock market investors to have is the right mindset. Having the right mindset can help you ride out the ups and downs of the market, and keep you focused on the things that really matter. It can also help you take advantage of the manic depressive Mr Market, buying shares when they are cheap and selling them when they are not so cheap.
That’s easy to say, but in reality most investors fail to buy low and sell high, and most investors fail to get anywhere near the returns of a simple, passive index tracking strategy.
So let’s take a look at this “investors mindset” and see if it can help us to do any better.
The safety of savings
Before I even get on to the subject of investing, I’d like to widen the scope a bit to include savings. Savings can mean many things, but to me it means putting your money into something where the original amount invested does not change – there is no capital risk, and you will always get back the amount you invested.
Let’s imagine that you’ve been given a £100,000 lump sum. What are some of your options, assuming you want to save it or invest it for some future purpose?
A savings account
Probably the easiest option is to stick the money into a savings account, which immediately raises the two most important issues in saving and investing: income and capital.
If the money goes into a savings account then there will an income, no matter how small. This income is also variable, with interest rates being changed periodically by the bank or building society. A quick search online shows me that you could get between 2.5% and 3% on that £100,000, paid either monthly or yearly.
As for the original amount put into the account, it does not change. If £100,000 is put in then it will still be £100,000 in 1, 5 or even 20 years, assuming the interest payments are withdrawn. Not only is the capital safe, but in most cases there is instant access too. If you wanted the money back tomorrow, you could get it.
Bonds – Swapping instant access for a higher return
One of the most common ways to get a higher rate of return is to lend your money to a bank, building society or company for a fixed period via a fixed-rate bond. In return for having complete control of your money for a number of years, the issuer will usually pay you a higher, fixed income.
Another quick search of the web tells me that you could buy a 5-year bond with that £100,000 and get a fixed income of 3.5% to 4% paid either monthly or annually. Although that doesn’t sound like much of an improvement, going from 3% to 4% means going from an income of £3,000 to £4,000; a relative increase in income of 33%.
This means that if there is at least a year or two before you need that £100,000 back, you would probably be better off putting it into bonds.
In terms of the capital amount, things are much the same as they were with the savings account. The bond issuer is contractually obliged to give you back your £100,000 at the end of the term, so the money is very safe as long as you stick with very high grade bonds.
So let’s assume that you want a higher return, and that you really don’t need that £100,000 for at least 10 years. What other options are there for getting a return higher than 4%?
Property investing – Inflation leads to higher returns
Most people understand the concept of using property as a cash generating investment and a store of value much better than they do the abstract, casino-like nature of the stock market. However, property and stock market investing have a lot of similarities, and the mindset of a good property investor is very similar to the mindset of a good stock market investor, so I’ll start with property investing.
Let’s say you find an apartment in an apartment block, on sale for £100,000. The current landlord has a tenant who is paying £6,000 a year. £1,000 of that has to be spent on maintaining the property, so the current landlord has a cash income of £5,000 from this property, which is a yield of 5% on the purchase price.
In this example you have immediately achieved a 25% higher income than the 5-year bond.; £5,000 instead of £4,000. However, the income is variable rather than fixed. Even if you have a contract with the tenant, you cannot be sure that they will actually pay the rent.
There is also the risk that when that tenant leaves after 6-months or so, you will not be able to find a new tenant immediately. If this takes several months then your income for that year will be significantly reduced.
So there is risk, or uncertainty, around the income. However, on the plus side an income from property has an interesting characteristic, which is the main reason why property generates far higher returns than bonds in the long-term.
The interesting characteristic is that as the years go by, rental income tends to go up with inflation.
This gives a useful boost to income returns. It means that over 10 years a rental income of £5,000 growing with inflation at 2% a year would become £5,975. In contrast the income from a fixed-rate bond would remain the same over the entire 10 year period.
The longer the time horizon, the more attractive the increasing income from a property investment will become. For a lot of investors, that growing income outweighs the fact that the income is variable and uncertain.
A growing income is an attractive feature of property investing, but what really sets it apart from bonds is the fact that the value of the property is also likely to grow in the long-term.
The capital value of an investment is has an unbreakable link to that investment’s ability to generate cash returns. The £100,000 apartment costs that much because it produces an income, net of expenses, of £5,000. This means that property investors are currently demanding a starting yield of 5% on their investment (assuming they are cash buyers, as you would be in this example).
If all investors wanted a 10% yield before investing in this property, then it would be valued at £50,000 instead of £100,000 (£5,000 income on a £50,000 investment is 10%).
So what will happen as the property’s rent increases over the years, more or less in line with inflation? Of course the answer is that the capital value of the property will also increase, more or less in line with inflation.
If we assume the world is a simple and perfect place, then with a £100,000 investment in a property over 10 years, with 2% inflation and a 5% rental yield, you would end up with a total income of £54,748 and a property worth £119,509. In other words, a total gain of £74,257 in those 10 years.
Compare that to a 10 year period in which the money was invested in fixed rate bonds with starting yields of 5%. In that case the total income would be £50,000 and there would be zero capital gains.
Property would come out better by £24,257, which is almost 50% better returns than the fixed-rate bonds, even though both investments have the same 5% starting yield. All of the additional returns come from the fact that property is an (approximately) inflation linked investment.
This leads to the first part of the investor’s mindset, which is that the most important feature of an investment is the cash income it will generate. Specifically: how much income, when that income is paid, and how much it will grow in the future. The more income that gets paid, the sooner it gets paid, and the more it grows the better.
On the face of it then, property is a much better place to store money over the long-term than either bank accounts or bonds. But it’s not quite that simple.
Capital risk leads to higher returns
Another key difference between bonds and an investment in property is that there is uncertainty surrounding the value of the investment. Although the value of the property is likely to go up in the long-term in line with inflation, that’s only true over periods measured in decades. Over shorter time periods of just a few years the value of a property is much more uncertain.
In other words, when the value of an investment is set by the market, there is no way of knowing what the value will be in the next few years. We can make informed estimates, but these are unlikely to be accurate.
For example, in 1999 the average house price was £67,478 (according to Nationwide), and in 2004, just 5 years later, it was £139,027, more than twice as much. But if you had bought the average house in 2007 for £175,554, then 5 years later at the start of 2012 its value would have fallen to £162,722.
One 5 year period leads to a doubling of value, while the other leads to a fall in value. Neither outcome could have been predicted in advance. This sort of uncertainty is an inherent feature of both the property market and the stock market (and many other markets too).
It’s only over periods of around 10 years or more that property investors can be virtually certain of making a capital gain in addition to their growing income.
So the second part of the investor’s mindset relates to time horizon. Because the capital value of investments is uncertain, even over periods of 5 years or more, an investment should only be made with money that is not needed for at least 10 years. Anything less than that and the chances of a capital loss increase enormously.
Lumpy income and illiquid assets
But there are problems with property investing. For example, the income on your £100,000 apartment could be very lumpy – you could end up going 6-months or more without a tenant. There could be a fire and you’d have all that hassle of sorting it out, plus there would be no tenant while the place was repaired.
Another problem is that if you wanted to re-invest the income back into more property, you can’t (assuming you want to be a cash buyer). The income in this example is £5,000, so you’d have to wait many years before you had enough to buy another property with. The same thing applies if for some reason you need to sell half of your investment; you can’t. You can only sell the whole thing or nothing.
Fortunately, solutions to the problems of lumpy income and illiquid investments have already been invented.
Size and diversification can lead to a smoother income
The apartment is in a block with 100 other apartments. Each apartment is for rent and so in the course of a year most of the apartments will be fully occupied, but in some cases there will be apartments that are without a tenant. Because there are so many apartments in the block, these occupied and empty periods tend to average out so that the rental income of the entire block is relatively stable and predictable. In most years it will go up smoothly with inflation.
This is in stark contrast to the fate of any single apartment, which may be fully occupied for years or may have long periods where it sits empty.
The only problem is that with 100 apartments valued at £100,000 each, the whole block will cost some £10,000,000 to buy, and unfortunately you do not have £10,000,000.
The wonders of shared ownership
Fortunately, a long time ago somebody came up with the idea of fractional, or shared ownership.
Imagine that the current owner of the building wants to sell, but he cannot find a buyer at £10,000,000, and he doesn’t want to reduce the price. Instead, he comes up with a plan to write out 10,000,000 contracts, each of which gives the holder the rights to a one 10,000,000th share of the apartment block. These contracts are commonly known as ‘shares’ and the current owner prices each share at £1.
This means that you, as a property investor, can buy 100,000 shares in the apartment block for £100,000. So rather than buying a single apartment with its lumpy income and its ‘all or nothing’ buying and selling characteristics, you can get a much smoother income and much more flexibility in when and how much you can buy or sell. For example, if at some point you really need to sell £1,000 worth of the property, then you can.
A market for shares
With 10,000,000 shares now available for this apartment block, it would be a good idea if there was a market where investors could exchange shares for cash, and vice versa. So let’s imagine that there is one.
This market would work in exactly the same way as an auction, where buyers and sellers come together and attempt to agree on a price in order to make their exchange.
As anybody who has been in an auction will know, the price that something sells for is driven as much by who happens to be bidding as by the intrinsic value of the thing being sold. The same is true of this market for shares.
If there are more buyers than sellers, then the price is likely to go up on that day. If there are more sellers than buyers then the price is likely to go down on that day. Ultimately, the value of these shares is determined by how much investors are willing to pay to buy a share of the future income that the apartment block will generate.
Liquid markets give rise to speculators
If that was as far as the story went, then perhaps it would all be very obvious, and there would be no need to spell out the investor’s mindset.
It would perhaps be obvious that an investment where the capital value is uncertain in the short-term, but is almost certain to go up with inflation in the long-term, should only be viewed as a long-term investment. Also, an investment that produces much of its gains by way of a cash income should be bought when the current and future cash yield is attractive in relation to other cash yielding investments.
But sadly, that isn’t as far as the story goes.
At some point the media – newspapers, TV news programs and more recently a huge number of web sites – realised that people wanted to know what their investments were worth. By effectively sitting in the auction room (the market) all day long they could provide every investor who read the newspapers or watched TV or surfed the internet, with the day-by-day and second-by-second movements in the price of the shares that the investors owned.
On the face of it that seems to be a useful service; but it isn’t.
What it does is drag in speculators who aren’t interested in the underlying property (as it is in this example), but only in attempting to predict what other speculators will pay for the shares tomorrow (or next week or next year), in order to buy the shares today so that they can sell them for a quick profit tomorrow (or next week or next year).
Worse than that, this constant flow of news about share prices can turn sensible, long-term investors into short-term, get-rich-quick speculators; although most of the time speculation is the quick route to the poor house.
It’s important to remember this: The market exists solely to give long-term investors a convenient way to buy and sell investments which would otherwise be far too expensive for them to buy, such as apartment blocks and large multi-national companies. It also gives them the ability to reinvest their income quickly and easily every month, rather than having to save up that income for years before having enough to buy another whole property or company.
That’s all it does. It cannot tell you whether or not an investment is a good one, just by looking at the share price movements.
The next part of my mindset for investors is this – On a day-to-day basis, Ignore the market. Investors focus on the property or company that they have invested in, while speculators focus on the ups and downs of share prices.
On their own, share prices have no meaning whatsoever. If a share price doubled last year, it means nothing. If the price fell by a half, it means nothing. The share price, whether for property, as in this example, or for a company, only has meaning when it is compared to the income which the investor expects the underlying asset (and therefore the shares) to generate in the future.
If in the examples above, the expected cash flows had not changed, then a doubling of the share price means that those shares are a worse investment because they are more expensive relative to the expected income. If the shares fall by half and the income is expected to be the same, then the shares are more attractive because the income returns are expected to be higher relative to the amount invested.
Of course, this is the opposite of what most people think and do, but it is what separates the investor from the speculator.
What does all this have to do with the stock market?
Hopefully it isn’t a giant leap to move from this picture of fractional, or shared, ownership of large cash generating property assets, to a very similar picture, but this time with companies instead of properties.
Instead of an apartment block of 100 apartments, imagine that you have invested £100,000 in shared ownership of 100 companies, by buying shares in a fund which tracks the FTSE 100. The end result is uncannily similar.
With the FTSE 100 we have a large, multi-billion pound asset that pays a reliable stream of cash to shareholders; a stream of cash that has grown for many, many years and is quite likely to keep growing at or above the rate of inflation for many decades (and perhaps centuries) to come.
If that picture is correct, the growing income stream will drive the capital value of the investment higher, and so eventually the share price will follow the dividends upwards, regardless of bull and bear markets, and regardless of the actions of speculators.
By staying focused on the cash generating features of the companies, rather than the movements of the share price via the stock market, the investor can make much more sensible estimates of future returns. This can be done in much the same way as it can with property, by looking for reliable, growing cash flows where the income is high today and expected to get higher in the years to come.
Once invested, the capital value of the investment should be more or less ignored on a week by week basis, and the investor should only consider selling if the market offers them an exceptionally high price, or if some other investment becomes available which is more attractive by a wide and obvious margin.
Ultimately, interested in is about long-term ownership, and long-term ownership is, to a large extent, about picking the right assets to own in the first place and then letting them get on and produce the growing income that you bought them for.