Top 10 Investment Principles

I’ve invested in the stock market since I was 17. Then wanted to “get better” at it and thus embarked on a journey of expensive courses offered by XP Investimentos: “Basics on Stock Market”, “Advanced Graphic Analysis” and “Fundamental Analysis”. The Basics on Stock Market course was all about tracking particular stocks and comparing them, distinguishing a certain stock against its industry, the correlation between sectors and international markets, as well as what was then the predictions for the future. I was amazed by watching how those stocks could have performed so well – conveniently of course the instructors did not mention that there is a survivorship bias when retrospectively watching stock performance history because the 90% of companies that went bankrupt are no longer being publicly traded on the exchanges and the chances of you, everyday investor, of picking up the next Amazon without the hindsight is extremely low.

Their Fundamental Analysis course was a summary of The Intelligent Investor book by Benjamin Graham and the Graphic Analysis consisted of Moving Averages and Fibonacci. That’s why I recommend people who are new to investing that rather than purchasing courses, save money to invest and read books from the greatest investors themselves such Essays of Warren Buffett; Intelligent Investor and Security Analysis by Benjamin Graham & David Todd; Principles by Ray Dalio; Renegade Capitalist on Carl Icahn; etc.

That being said, I tried to create a top 10 list of investment principles that the broker courses would teach you:

1. Currency Cost Averaging

Currency-cost averaging is an investment tool of buying a fixed currency amount (i.e pounds) of a particular investment on a regular schedule (e.g every last day of the month), regardless of the share price. The result is that the investor purchases more shares when prices are low and fewer shares when prices are high. This ensures value investing which consists of the habit of buying low and selling high.

This process can be automated through your investment platform and give you peace of mind with the operation. Remember: when it comes to the investment field, your worst enemy is yourself and therefore automating your execution can be a clever plan to ensure you are paying yourself first. See below an example of the function in action.

Image result for dollar cost averaging


2. Compound Interest

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it” – Albert Einstein

Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit – it can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.

The formula for calculating compound interest is:

Compound Interest = Total amount of Principal and Future Value less Present Value

= [P (1 + i)n] – P

Example of compound interest at work.

Because of compound interests, the more you save in the early days, the more that money will compound and will become a bigger sum.


3. Tax Efficiency

Tax efficiency is an attempt to minimize tax liability when given many different financial decisions. There are many ways to obtain tax efficiency, including selecting tax efficient vehicles such as many exchange traded funds (ETFs) and municipial bonds, pension schemes, ISA or Lifetime ISAs.

Image result for Tax Efficiency uk


4. P/E Ratio

The price-to-earnings ratio is the ratio of the market price of a company’s stock to its earnings per share (EPS):

P/E Ratio = Market Value per Share
—————————————————————————————————–
Earnings per Share (EPS)

If a company’s shares are trading at £20 and it’s earnings per share was £1.25 over the past year, the P/E would be 16x. The P/E is often expressed a multiple of earnings. This facilitates the comparison between different stocks and the intrinsic value of a company. If a second company in the same industry was trading with a P/E of 10x, you would have to determine if one was overpriced relative to the other.

Benjamin Graham, father of value investing theory and mentor to Warren Buffett, popularised PE ratio by looking at P/E 10 or P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500 since these longer term measures can compensate for changes in the business cycle.


5. Moving Averages

Different investors use moving averages for different reasons. Day traders use them as their primary analytical tool, whilst others simply use them as a confidence builder to back up their investment decisions.

The most basic type of crossover is when the price of an asset moves from one side of a moving average and closes on the other. Price crossovers are used by traders to identify shifts in momentum and can be used as a basic entry or exit strategy. As you can see in Figure 1, a cross below a moving average can signal the beginning of a downtrend and would likely be used by traders as a signal to close out any existing long positions. Conversely, a close above a moving average from below may suggest the beginning of a new uptrend.

Figure 1: Font chart by MetaStock, 2006.

The second type of crossover occurs when a short-term average crosses through a long-term average. This signal is used by traders to identify that momentum is shifting in one direction and that a strong move is likely approaching. A buy signal is generated when the short-term average crosses above the long-term average, while a sell signal is triggered by a short-term average crossing below a long-term average. As you can see from the chart below, this signal is very objective, which is why it’s so popular.

Figure 2: Font chart by MetaStock, 2006.

Responsiveness to changing conditions is accounted for by the number of time periods used in the moving averages. The shorter the time periods used in the calculations, the more sensitive the average is to slight price changes. This type of average is good at identifying long-term trends/reversals. The one I have operated with most accuracy was both dynamic averages at first 9-day vs 27-day, but it all depends on how often you’d like to trade.


6. Fibonacci Extensions

Market Resistance: It’s the latest highest point that the market has reached. Usually when the market crosses a market resistance one of two things happen: i) it bounces right back from where it was before it touched and declines or ii) it tends to capture momentum and continue the uptrend. The more frequent the market has reached the same resistance point, the stronger that resistance line becomes.

Market Support: The opposite to resistance, it is the latest lowest point that the market has reached recently.

Fibonacci extensions are used in Fibonacci retracements to predict spaces of resistance and support in the market. These extensions involve all levels drawn past the basic 100% level; they are frequently used by traders to determine areas that will bring in profits. One popular extension, the 161.8% level, is used to set a price target on a breakout of an ascending triangle, this target is calculated by multiplying the vertical distance of the triangle by key Fibonacci ratio 61.8%, and then adding the result to the triangle’s upper resistance level.

Fibonacci Extensions

A retracement movement of a stock is where the stock “retraces” a section of one of its previous moves. In most cases, a stock performs a retracement at one of three standard Fibonacci levels: 38.2%, 50% and 61.8%. When a stock retraces more than 100% of its prior move, a Fibonacci extension can be calculated. These extensions, used in combination with a variety of other indicators or patterns, are common practice for traders looking to determine one or multiple price targets.

Practical Use

It is best, and most practical, to calculate Fibonacci extensions when stocks are at new highs or new lows, and when there are no clear levels of resistance or support on the chart. If, for example, a trader is long on a stock and the stock begins to generate new highs, the trader can calculate Fibonacci extension levels to get a basic idea of where the stock is likely to fall and is more likely to make profits. The same is true for a trader who is short. Fibonacci extension levels can be calculated to give the trader a general idea of where the stock may begin to rally. The trader then has the option to decide if he wishes to cover his position at that level.

Fibonacci extensions are applicable to any timeframe, such as monthly charts to one-minute charts, and are tools best used on price waves so projections of future price waves can be generated. It is also wise for traders to note that clusters of Fibonacci levels are indicative of a price area that will inevitably be significant. The most important aspect traders should know is Fibonacci extensions should never be the sole deciding factor when making trading and position choices.

Moreover, whatever graphic analysis tool you use, you always need to take into consideration the volume levels of the the candlesticks. If a market has low volume means that not many transactions are determining the trend in the market and therefore your Fibonacci or Moving Averages are likely to fail. Conversely, if the volume is high, your graphic analysis is more trustworthy as there is a clear and strong trend being formed by the mixture of millions and millions of traders and transactions.


7. Admin fees and the Case for Index Funds

Mutual funds which are the most common funds charge you a fee of 0.5-2% a year. This means that if your return for that year was 5%, you’re only receiving 3-4.5% return before taxes. The truth is that 96% of actively managed mutual funds do not beat the market over a 15-year span. Active managers are trying to beat the market by being a great stock picker. And the 4% that does beat the market is changing all the time, so betting on a jockey that won the last race does not mean that he will win again. Chasing performance is a fool’s errand. These highly educated managers charge you for their poor performance! Another learning here: do not try to time the market. If these people who studied the market and work on it 24×7 achieve poor performances, imagine what the average investor would achieve compared to an index fund?

How badly does this actually hurt us? Over a 20-year period – December 31, 1993 through December 31, 2013 – the S&P 500 returned an average annual return of 9.28%. However, the average mutual fund investor made just over 2.54%, according to Dalbar, one of the leading industry research firms. That’s nearly an 80% difference!

What’s an index fund? Your fund provider will automatically balance your portfolio via algorithms with the biggest companies in the region you have your fund. Let’s take the S&P 500: you essentially have tiny bite-sized stocks in every single top 500 US companies across a diverse array of sectors and services bringing your asymmetric risk return. What a beauty! Moreover, like Darwin’s natural selection theory, if a company goes through the cracks as soon as they occupy the 501st position, guess what? That’s right you no longer own then, but rather have a rising star coming up to replace it.

Lowest admin fees of an index fund:

Fidelity

  • UK FTSE 500 index fund = 0.06%
  • US S&P 500 index fund = 0.07%

Vanguard:

  • UK FTSE 500 index fund = 0.08%
  • US S&P 500 index fund = 0.05%

Try to avoid hopping on and off from your position, this just make your operations more costly as you pay more and more fees to your broker.

Ask a barber whether you need a haircut and count how many times he says no” – Brokers and their courses will always incentive day trading because that’s how they make the bulk of their money. If you’re taking these courses though, be very cautious with how frequently you get accustomed to trade in and out of a position.

If you want to apply to understand more about your net return influenced by compound interest and your broker fees use the True & Fair Calculator to get an accurate view


8. Assets Correlation

In a globalised and interwined world, every asset is somewhat correlated. Generally, companies in the same industry in the same country have a significant correlation in a span of five years, meaning that if Apple stocks skyrocket, Samsung stock may start playing some catch up in a matter of time.

Because of how correlated the global markets currently are, 2009 was a disaster not only in the USA where the crisis began but eventually in the entire world as the financial system was and still is at an all time high level of correlation.


9. Economic cycles

A simplified economic model would include three variables: productivity growth, short term debt cycle and long term debt cycle. These variables create the bull (ascending market) and the bear (declining market).

Productivity Growth: It’s what creates real value and what makes capitalism be able to create electricity, cars, supercomputer phones, bio medicine, etc.

Debt: is a what brings our future into the present when used wisely. Good debt is low interest rates and allows you to buy appreciative assets (something that will increase in value over time). Conversely, bad debt is high interest rates and generally is for used of goods that will decrease in value over time. Examples of good debt goes as a mortgage to your house or a student loan to pay for your university.

Debt has two cycles: Long term debt cycle and Short term debt cycle as per the figures below.

Image result for Long term debt cycle Short term debt cycle Productivity ray dalio graphSource: Ray Dalio’s Economic Principles at Work Template

These debts need to be re-paid to maintain system credibility and the optimum state is to be able to expand productivity and align it to long term debt cycle. The short term debt cycle last 5-8 years with its bulls and bears i.e 2002-2010 and that’s why we have a stock market crash every 5-8 years – that’s caused by the short term debt cycle.

Image result for Long term debt cycle Short term debt cycle Productivity ray dalio graph

The long term debt cycle consists of a much longer timeline 75-100 years whereas after the leveraging of 50+ years, a depression happens such as 1929 and then the “lost decade” proceeds it by austerity measures to decrease the debt and recap the economy to the level it was before the depression happened. It happens once a lifetime and that’s why people generally don’t remember it vividly.

Image result for Long term debt cycle Short term debt cycle Productivity ray dalio graphSource: Ray Dalio’s Economic Principles at Work Template

Those are in effect the reason why we experience market corrections of 10% every year, market crashes every 5-8 years and economic depression every 75-100 years. For further explanation, visit How the Economic Machine Works by Ray Dalio.


10. Diversification

Diversification is the only real free lunch” quote popularised by the Nobel prize-winning economist Harry Markowitz in the 1950s.

If you get only thing from this post, please understand that 99% of people who succeed stock picking have an advantage over you being either: i) information advantage (they know something that you don’t – a professional hedge fund manager have a top tier MBA and many years of daily trading experience); ii) network advantage (they know closely the board of directors of many top companies); iii) behaviour advantage (they have strong performing habits that have been tested over and over for many years – best example: Warren Buffett). Therefore, your best shot as an average investor is to diversify your portfolio and put your eggs into different basket. Read my other article for more on that: Investing as a Millenial.

1 thought on “Top 10 Investment Principles

  1. Amazing reading! I will need more time to understand it deeply😂

    Like

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