Apalla #19 – Investing, Part 1

In our new series, we’re going to be going over the basics of investing. Buckle up, because this is going to be one of our longest series on Apalla to date!

Before we go over different financial instruments, or valuation measures, or anything like that, we’ll be starting with key principles. This might seem counterintuitive at first; most of our series in the past have started out by defining the landscape, and then moving on to the nitty-gritty. In this case, however, I think these overall tips help paint the picture more generally while still providing some advice that extends beyond just investing. That’s the one beauty of finance — a lot of the tools you’ll learn here extend very well to the outer world. You’ll understand better when I describe them, so let’s just dive right in!

The first rule of investing is that you cannot predict the future. Many people confuse the sport of investing as a measure of prediction and forecasting — while these methods are sometimes used, they don’t serve the main point of finance. The main point of finance is finding the greatest amount of return for the lowest amount of risk, and that does not necessitate knowing how to predict things five years in the future!

Typically the way the market works is that the more volatile (risky) an instrument is, the higher price it can achieve (return). To keep things simple, we’ll say we can have an instrument that has a high chance of going from $50 to $100 in t periods, it must have an equally high chance of going from $50 to $100. If an instrument can go from $50 to $52 in t periods, it will probably only fall from $50 to $48 within that time frame. This rule of normal distribution isn’t perfectly accurate, but it helps us to describe elementary risk. 

So, why does this happen? It is typically so due to the fact that markets are efficient based on the number of participants. Say, remember the wisdom of the crowds idea from our Statistics series? It comes into play here as well — if there are a large number of individuals trading on a certain instrument, then that instrument is likely going to be near its true price and doesn’t have a high chance of going anywhere. Alternately, if an instrument only has a few buyers/sellers on it, there’s a lot more variability in its up and down. This isn’t the only reason an instrument becomes risky, but we’ll be going more into the other reasons just a bit later.

So now we know that there are risky and not-so-risky instruments, and that we cannot predict the future. Well, this presents an issue, an issue that just so happens to be the number one problem of all of investing: if we can’t predict the future, how do we obtain high returns? Remember that in order for the high risk instruments to give us high returns, we have to be right that they’ll go up rather than down — but we can’t do that! That doesn’t make high risk instruments useless, that just means we can’t pick and choose the right stocks every time. It’s fundamentally an impossible exercise.

Now, there are many answers to this high return problem. For our purposes, we’re going to focus on a specific solution called the value investing solution. This solution isn’t perfect, but it is certainly the easiest to learn and provides us with some quite good results. The value solution essentially says that looking at high risk instruments is (for the most part) useless, and we should instead focus on keeping the highest return for the lowest risk a priority. In this method we treat financial instruments about the same way you’d treat buying groceries at the store, looking at what looks good and seeing if you can grab a sale on it. 

There’s two central ideas behind value investing: avoiding bad instruments and keeping low costs a priority. Starting with the first idea, we quote the famous investor Howard Marks: “Avoid the losers, and the winners take care of themselves”. Essentially the main goal here is the opposite of stock-picking: we’re trying to avoid nasty deals and stocks about to go under. We don’t look for companies that are achieving massive growth, but rather companies that are very healthy financially. Similarly, we don’t use any complicated financial “derivative” instruments that we can’t easily understand (such as MBS, or “mortgage-backed securities” — complicated real estate derivatives that brought down the stock market in 2007-2008). 

Just so we’re clear here: there’s nothing wrong with growth instruments or derivatives. When used right, these instruments can provide a much higher return — but in order to use them properly, you’ll need an extensive math background and a great understanding of the markets. Not very beginner friendly! So that’s why we’re sticking with value investing principles. 

The second idea is to keep costs low. This doesn’t just mean the price of the instrument — it also means hidden fees and taxes as well. John Bogle, the father of mutual funds, believed that the most important numbers to look at were not an instrument’s incomes, but an instrument’s expenses — numbers like expense ratios and fund fees which we’ll get into in a later episode. We also want to be careful of capital gains tax (the money you get taxed selling an instrument, which goes down the more time you wait to sell it) and dividend tax (the tax on cash disbursements for an instrument). 

This is already the longest episode on Apalla thus far, but I’d be remiss if I didn’t tell you about one more essential factor in investing: diversification. Remember when I said risk wasn’t just related to the amount of participants on an instrument? Well, it turns out there are two types of risk: systematic and nonsystematic, though I refer to them as universal and individual to keep things easier. 

Universal risk is risk you cannot avoid, because it affects all instruments equally. For example, when COVID-19 hit, everything went down — no good investing method would have saved you. On the other hand, there is individual risk, which involves the risk of a single instrument. So we could have an instrument go all the way down to 0, without really affecting the rest of the market. 

As it turns out, this individual risk we can get rid of — and we can get rid of it using a method known as diversification. When we invest in many different instruments, the fact that one instrument goes low no longer effects us — because it’s cancelled out by all the others! We’re going to see the idea of diversification play out more into the future, but it is important to keep this idea in mind early on. 

It’s also important to know this idea works both ways — the lower risk from diversification is also going to mean lower reward. Because of this, investors often see it important to create several different diversification “portfolios” with different levels of diversification and therefore different levels of risk and return, like so:

  • Protective portfolio: Focus on low risk. Many low risk instruments.
  • Market portfolio: The middle ground. Many instruments, both high risk and low risk.
  • Aspirational portfolio: Focus on high return. A few good-looking high risk instruments.

Typically these portfolios will change in size over time, with young adults being focused in aspirational (where growth is essential and risk doesn’t effect as much) and elderly being focused in protective (where stability is essential and risk hurts a lot). 

Alright, that’s it. I know that was a lot, so feel free to email back if you have any questions! Next episode, we’ll be talking about our first major instrument — equities, also known as stocks. See you then!

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