Everyone has the intellectual skills to successfully choose stocks to your portfolio. However, this stock picking requires an in-depth analysis of each stock. Such an analysis may take quite a while and involve reading financial data, some mathematical calculations, time and effort that many investors do not wish to dedicate. However, there are also passive investment options to earn from investing in stocks without the need for deep accounting skills, and with little time spent analyzing companies. The most important thing is that you choose the right way for you.
Benjamin Graham, the father of Value Investing, presented in his excellent book “The Intelligent Investor”, the two wise investment paths that you have:
1. Dynamic management of a more focused portfolio based on selecting investment ideas after conducting thorough research on each idea.
2. Building a fixed (or less dynamic) portfolio which is managed automatically and does not require any special effort to manage it. This is similar to a pilot switching the auto-pilot on and is the strategy that fits most investors.
The first approach is active since it requires time and energy from the investor, while the second strategy is passive and doesn’t require any effort at all. Each approach has its own difficulty: while the active strategy is intellectually demanding and requires time, the passive strategy is easy to apply but is much more emotionally difficult to hold on. Let’s examine the two strategies to better understand which is best for you.
The passive investor and the automatic stock portfolio
If you do not have the time or the will to deal with numbers and financial data, you are probably a passive investor, thus the passive approach will be the most suitable for you.
In such a case, it is best that you stay away from conducting financial analysis or valuations of companies. You must concentrate on building a diversified investment portfolio that you will maintain over the years regardless of the market conditions. One option for a passive portfolio is by using an Exchange Traded Funds (ETF). An ETF is a basket of stocks that are imitating one of the indices in the market (e.g. the PowerShares QQQ ETF tracks the Nasdaq 100 Index, which contains the 100 largest technological companies in the US).
The passive portfolio should be build of few ETFs that copy the behavior of various stock indices around the world. One investment strategy that can be used here is the Dollar Cost Averaging strategy, in which you buy more units from your ETFs in a constant amount of money each month, and thus increase your investment.
Another method that may be adequate for the passive investor is by using an automatic value-investing strategy, such as Graham’s Net-Net strategy. These strategies are based on choosing 25-30 winning stocks of companies that have strong balance sheet but for some temporary negative reason are traded at low valuation. Each stock is usually held for 1 year and then replaced by a new winning stock. This method is passive since the choice of shares in the portfolio does not require in-depth analysis, but is done by quick selection of shares that meet a few simple criteria.
If you chose to go the passive way, you do not have to devote too much effort to studying the next three lessons (although they may be interesting for you) which discuss the financial reports and analyzing the value of companies. Alternatively, focus on the psychological aspect of investing and learn how to ignore market volatility and negative macro news that affect stock prices in the short term. This will help you to stick with your plan and succeed in the long term.
The active investor and the dynamic stock portfolio
In “active” we don’t mean day-trading; we mean active analysis of companies leading to decision of which stocks to buy to our portfolio, and later on decide when to sell them. If you have the time, the will and the knowledge that required for conducting this kind of deeper analysis of companies, then the active approach can be the smart and most rewarding thing for you. This approach is performed by Warren Buffett and all the most successful gurus in the world for years.
In contrast to the passive investor, active investors should spend a lot of time studying how to read and understand the financial statements of companies, read more reviews and articles about the company you are analyzing in order to better understand its type of activity, quality of management, competitiveness (sometimes refers as moat) and more.
You will need to learn valuation techniques such as Discount Cash Flow (DCF) valuation, which will be discussed later in this tutorial, and other valuation methods, so that you can assess the true value of the company. You will also need to be much more cautious and make sure that the stocks you buy into your more focused portfolio will be purchased at large discounts below their fair price, so that margin of safety will protect your purchases if they are misjudged. The active investment approach is definitely not easy to perform, but if you succeed it will reward you big-time.
Which method to choose?
Both passive and active strategies are equally wise and you can be successful investor in any way you choose. You can also choose a combination of passive and active methods and build a portfolio that is partly managed according to the passive principles and the other part will be managed dynamically according to the active way.
If you chose the passive way, try to keep it simple; use ETFs or stock selecting method based on constant set of criteria and adhere to these criteria over a long period of time regardless of the market conditions. If you choose to be an active investor, learn how to build and manage a focused stock portfolio, and choose the stocks for your portfolio only after you have thoroughly analyzed each one. Remember that your success lies mainly in choosing the right path for you, passive or active (and perhaps a combination of the two), and keep with it for many years, using logic and ignoring your emotions. This will lead you to success.
Read on to the next chapter: