CHAPTER 2:
Is it safe to invest in stocks?
When most people hear the words "stock market" or investments, the image of a casino comes to mind. Ninety-nine percent of ordinary people believe that investing is very risky. It is something reserved for a select group of people with money. For them, the safest thing is to have money deposited in the bank, or in the worst-case scenario, under the mattress. Very far from reality.
Investing is the least risky way to preserve wealth and accumulate money in the long term. But let's clarify some concepts first.
INVESTING IS NOT SPECULATION
Investing and speculating are two very different things. Investing consists of acquiring an asset, generally long-term, with the intention of generating returns for us. Speculating consists of trying to predict the behavior of the price of an asset in order to sell it for a greater sum than what you initially acquired it for. Buying a business like a restaurant and operating it is investing. Buying one kilogram of seafood two months before Christmas is speculation. That, as well as anything else that involves relying solely on the price of a good to make assumptions about the future. Speculating is extraordinarily risky and leads most speculators to lose money.
STOCKS ARE COMPANIES
Secondly, investing in the stock market is not the same as gambling at a casino. Stocks are not lottery tickets; each stock represents a small part of ownership in a company. Owning Coca-Cola shares is exactly the same as owning the entire company of Coca-Cola, but with the great advantage that we do not need to have the $250 billion that it costs in the market.
Stock prices do not rise and fall randomly. Their long-term performance will accurately represent how well the company's business is doing and how much cash it can generate. However, in the short term anything can happen. In periods of hours, days or even weeks, what moves the market are speculators. In the short term, it is their feelings of greed or fear that move the price in one direction or another.
Thirdly, the market cannot be predicted. Get this clearly in your mind, because it will save you from doing a lot of stupid things. There is absolutely no one in the world who can draw a few lines on a chart and tell you with 100% certainty that tomorrow the price of a certain stock is going to rise. It is totally impossible. But then. how do traders make money?
To answer that question, let's move for a second to a place that speculators would love, a casino. It is well known that there have been certain individuals who developed gaming strategies allowing them to win consistently at Black Jack, but how did they do it if it is a random game?
Simple, they spent their time trying to find anomalies in the game or the environment that gave them a certain statistical advantage. They managed to adapt their gambling method so that it gave them a small chance of winning certain games. For example, a 50.1% probability of winning versus 49.9% of losing. Then they just needed to repeat their system countless times to take advantage of their statistical edge and make a few dollars consistently.
The system used by traders is similar. If you ask the average trader if a stock is going to reach a certain price, they will be just as successful at guessing it as if you were to ask a monkey pointing out numbers while blindfolded. In fact, it is likely that the monkey would be more successful.
DON'T DO TRADING
We have said that the price is impossible to predict in the short term, but it is also true that prices tend to generate certain patterns on the charts. Everything related to technical analysis: channels, supports, resistances, gaps, Elliott waves, Fibonacci retracements, etc. To some extent, having a bunch of speculators using the same systems makes those patterns into self-fulfilling prophecies. The key words in all of this are "tend to". Trying to justify accurately what levels the price of a stock will rise or fall to is useless.
The best and most experienced traders typically have an average success rate that does not usually exceed 60% of their total bets. What they do to earn money consistently is try to manage their risk strategies properly by attempting to win a lot when they succeed and losing very little when they fail. They look for strategies with the best risk-reward ratios, letting profits run on the ones that are right and quickly closing their positions on the ones that are wrong. In this way they take advantage of the small statistical edge that separates them from the fifty-fifty.
The big problem is that trading is a zero-sum game. Wealth is not created like when a company distributes its earnings to you. In trading and speculation, money only changes hands. For a few to win, many others must lose. If you think you can beat trading professionals or large institutional investors at their own game, give it a try. But you will almost certainly lose money. Stay away from technical analysis and speculation. Be a value investor, and you will not need to compete with anyone; the guys in the companies you own will make money for you. Forget about technical analysis from now on and become a business owner, not a casino gambler.
DIFFERENCE BETWEEN PRICE AND VALUE
Fourthly, you must know how to differentiate between price and value. Just because your stock price drops at a certain time does not mean you have lost money, as long as you do not do the injudicious thing of selling after a downturn. The trading price of a share is nothing more than an irrelevant number generated by the greed or fear of speculators, which fluctuates all the time up and down around the really important number, which is the value of the company.
The value of the stocks is actually what the company's assets are worth plus all the cash flows the business will generate in the future. If the price of a stock falls, but the company is still just as good and earning the same amount of money, then you have not lost anything. The underlying value is still there, no matter what the price says. When the right time comes, the price will reflect the real value.
You only lose money if you are foolish enough to sell your assets for fear of a drop in price, following the collective hysteria of the market. It would not be wise to sell your shares in the world's best company just because they have dropped by 50%. The company will continue generating value and in the long term it will rise again. If you are scared because your shares are falling while the company is earning more and more, then you do not understand anything about the difference between price and value. We will talk more about this concept in the next chapter.
RISK IS NOT VOLATILITY
Finally, another concept that we must be clear about is what "risk" really is. Usually, risk in the stock market is identified with price volatility. This is another of the biggest mistakes you can make. In the same way that you do not go to a real estate site every day to check the price of your newly purchased house, you should not do it with your stocks either. The risk in the purchase of your house has nothing to do with the fact that tomorrow apartments similar to yours will be sold a little cheaper.
If the stock you own declines by 90% due to market insanity, but the company remains as strong as before, then you do not have more risk; you have less. That is when you should buy, not sell. The lower the price, the lower the risk. If you are going to be a net buyer of stocks in the long term, what you want for prices is to be as low as possible. You want them to be cheap, just like you want cheap bread when you go to the supermarket. The real definition of risk is losing money permanently, meaning that the business goes bankrupt or loses its ability to generate earnings.
The bottom left chart shows a company whose profits have grown exponentially over time, but its price has remained flat and highly volatile. On the other hand, the lower right chart represents a company that has kept its earnings almost constant. However, its price has skyrocketed, also rising with almost no volatility. Which stock do you think is riskiest at the end of the period?
Clearly, the riskiest stock is the one on the right side, as its price increase has not coincided with an increase in earnings and therefore it is becoming more and more expensive. It is a clear candidate for a long period of stagnation or an extremely important collapse simply due to the regression to the mean of its usual multiples. The company on the left side will witness its price skyrocketing in the long term, following the growth of its earnings.
It is also generally accepted by the herd that cash is very safe. Bonds are considered the safest asset after cash, while...
