Introduction
Investing is an activity that is often made unnecessarily complex. Many investment professionals, such as financial advisers and portfolio managers, too often contribute to their clients’ confusion by failing to adequately explain basic financial concepts.
In this guide, we explain five of the most important concepts investors should know before making financial decisions. While one concept, active vs. passive investing, refers primarily to financial assets such as stocks and bonds, the other four concepts apply to investments in other asset types, including real estate and private businesses.
1. Time Value of Money
Money has time value in the sense that a monetary sum today is worth more than the same sum in the future. This is not only due to inflation, or the decline in money’s purchasing power over time, but also because of:
- The uncertainty that the future sum will be realized; and
- The foregone interest that could have been earned over that period.
An investor can determine the worth of a future sum through a mechanism known as discounting. The value derived from discounting a future sum is the present value.
The formula for calculating present value is:
PV = FV / (1 + r)n
where FV is the future sum, r is the investor’s desired rate of return per period, and n is the number of periods.
Conversely, the investor can calculate the future value of a present sum through a mechanism known as compounding. Compounding refers to the actual rate of growth of a sum over a period.
The formula for calculating future value is:
FV = PV(1 + r)n
where PV is the current sum, r is the investor’s desired rate of return per period, and n is the number of periods.
2. Opportunity Cost
Because an investor’s monetary resources are limited in quantity, the investor must choose among competing investments. To pursue one investment, the investor must forgo other investments with similar risks.
The return that is foregone when the investor pursues one investment over alternatives is the investor’s opportunity cost. This concept is the basis for an investor’s desired return, or required return, on a specific investment.
Suppose, for example, that an investor is presented with a bond yielding 5%. The investor determines that bonds with similar risks are available with 7% yields. Despite the positive return on the 5% bond, the investor would suffer an economic loss of 2% because the investor had foregone a 7% yield on a similar instrument.
This is an important point: an investor will only increase economic wealth when an investment offers a return in excess of the investor’s required return.
All investors can earn, with minimal risk, the rate on short-term government securities — a rate often referred to as the risk-free rate. An investor’s required rate of return on a specific investment should therefore be a function of:
- The risk-free rate; and
- An appropriate risk premium.
While the rate on short-term government securities is generally used as the risk-free rate, the asset’s risk premium is more subjective. However, the asset type’s average historical returns minus the rate on government bonds is often used as the asset’s risk premium.
For example, stock investors may use the average returns on the S&P 500 stock index minus the rate on the 10-year government note as the appropriate risk premium for analyzing a stock.
3. Active vs. Passive Investing
Investors in common stocks must decide whether they should actively select stocks, hire someone to do it for them, or invest in a fund that mimics a stock index, such as the S&P 500.
Since an investor can match the returns of a broadly diversified index such as the S&P 500, the returns on this index represent the stock investor’s opportunity cost.
Active stock selection represents a stock portfolio based on fundamental or technical analysis.
Fundamental analysis involves analyzing a company’s financial statements and business prospects to determine whether the stock offers a favorable risk-return tradeoff.
Technical analysis relies on reading stock-price charts to forecast the future movements of stock prices.
Regardless of the method of stock selection, most individual investors have neither the time nor the training to select stocks on their own. However, investors can hire professional portfolio managers to select stocks for them.
The most common form of professional management is through mutual funds, which are commingled pools of professionally managed capital. High-net-worth investors may also invest in hedge funds, which are private investment partnerships that often employ more complex investment strategies.
Finally, some firms offer professional portfolio management through separately managed accounts, in which stocks are held directly in a client’s individual account.
Financial markets are highly competitive, and many professional investment managers fail to earn returns in excess of returns on passive instruments. If an investor decides to seek out the services of a professional manager, the investor should ask the manager what his or her investment “edge” is — that is, the reason why the manager believes he or she can generate excess returns.
If the manager cannot convincingly articulate an investment edge, the investor should consider a passive instrument such as an index fund.
4. Diversification
In its simplest form, diversification refers to an investor’s spreading of risk by investing in assets whose returns behave differently in different economic conditions.
Investors should diversify among asset classes, such as stocks, bonds, real estate, and other assets, and among individual securities within each asset class. Diversification is one approach to reducing an investor’s risk.
Diversifying among common stocks can help reduce firm-specific risk, also called nonsystematic risk. This is the risk that the value of a company’s stock can become impaired due to circumstances unique to the company.
One mathematical approach to diversification is modern portfolio theory, or MPT. MPT employs mathematical techniques to optimize the relationship between a portfolio’s risk and its expected return.
MPT uses an asset’s past price volatility as a quantifiable measure of risk, with volatility being measured as period-over-period deviations from average returns. The specific metrics are variance and standard deviation.
By selecting securities whose past returns are uncorrelated — between a measure of 1 for perfect correlation and -1 for perfect negative correlation — investors can construct an “optimum” portfolio, meaning a portfolio offering the lowest volatility for a given level of expected return.
While we agree with the conceptual framework behind MPT, we are skeptical of its use for several reasons.
First, MPT deemphasizes the role of fundamental analysis and stock valuation. Under MPT, a stock may be selected for its diversification benefits to a portfolio, rather than because the stock is undervalued.
Second, we believe price volatility is a poor measure of investment risk. In our view, investment risk is the potential for a permanent impairment in an asset’s value. Too many factors can contribute to an investor’s loss to be captured in a single variable.
Third, for the MPT practitioner to rely on past returns, she must determine both:
- The interval of those returns, such as weekly or quarterly; and
- The length of time over which the returns are observed.
Changing the intervals and length of the observations can significantly alter the MPT mathematics.
Finally, MPT assumes that past statistical relationships will persist in the future. This can be a flawed assumption when, for example, a company is in a different business than it was in the past.
Despite our skepticism toward MPT, investors should diversify among asset classes and individual securities. When constructing portfolios, investors should think about how each asset will respond to different economic conditions.
5. Margin of Safety
Value investing is a method of investing in an asset when the price of that asset is significantly below the investor’s appraisal of fundamental value. This difference between value and price is what Benjamin Graham, the father of fundamental stock analysis, referred to as the margin of safety.
A reliable appraisal of fundamental value is key to the margin of safety concept. Valuation is generally derived by either discounting the asset’s expected future cash flows, known as discounted cash flow, or DCF, analysis, or by observing prices of comparable assets.
In our opinion, DCF is the more theoretically sound method of asset valuation.
In a previous section, we presented the formula for calculating the present value of a single sum. For a perpetual cash flow stream used in the basic DCF model, the investor uses the following formula:
Value = CF / (r – g)
where CF is the asset’s current cash flow normalized to eliminate nonrecurring items, r is the investor’s required return, and g is the perpetual rate of growth of the cash flows.
The above formula gives the investor a value against which the asset’s price can be compared. While the components can be subjective, the investor can enhance the usefulness of the valuation by using conservative assumptions.
In addition, by pairing the margin of safety concept with the concept of diversification, the investor can create a sound portfolio framework.
Conclusion
While we have presented what we believe to be five of the most important investment concepts, we must recognize that these are not the only important investment concepts. Education in this field, as in all fields, is best thought of as a journey.
We hope this article represents a useful first step.
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Sources
Defusco, Richard A., Dennis W. McLeavey, Jerald E. Pinto, and David E. Runkle. Quantitative Investment Analysis, 2nd ed. Hoboken: Wiley, 2007.
Graham, Benjamin. The Intelligent Investor, revised ed. New York: Harper Business, 2006.
Reilly, Frank K. and Edgar A. Norton. Investments, 6th ed. Mason: South-Western, 2003.
