An investing strategy should be unique to each individual’s goals, risk appetite, and values. The most important piece of advice I would give to anyone looking to invest is to pick your strategy and be consistent with it. Markets fluctuate, interest rates change, and economies have many complex dynamics. Sticking with a sensible game plan, in the long run, will lead you to grow your money and accumulate wealth.
The key to success is thus finding a winning strategy that works in most conditions with your chosen investment class. There will always be outliers to any plan, but there are several fundamental criteria that we’ll focus on here.
Generally speaking, the smart and successful capital managers of the world implement a few concepts and objectively apply them to allocate resources effectively. Warren Buffett, arguably the best stock picker in the world, has given his two rules for investing:
Rule #1: Don’t lose money
Rule #2: Don’t forget rule #1
Simple, logical, straightforward, and much easier said than done. One of the most commonly known ways to adhere to Buffett’s rules is to buy low, sell high. Economically sound advice for anyone wanting to grasp the basics of how to make money in asset management.
Surprisingly, novices and experts alike sometimes fail to follow this simple principle and windup bailing on a quality investment once it starts to show signs of decline. You might look at your portfolio’s performance on a monthly, weekly, or daily basis (but don’t do this) and see a downturn with one or more investments. Uncertainty and doubt may lead you to want to drop those poorly performing investments. In some cases, it could be the right decision to cut your losses and move on. However, if you’ve done your research, analyzed the investment accurately, decided that it fits your portfolio strategy well, and have strong reasons for buying it in the first place, then you may want to give it time to recover and trust your assessment of the quality of the investment.
Two driving forces will determine how you put your money to profitable use when formulating your investment strategy. The two primary methods for making money from assets are capital appreciation and dividend income.
Capital Appreciation
Essentially, capital appreciation is effectively buying low and selling high. If you purchase an asset today and it goes up in value, then we say it has appreciated. Selling an investment for more than you paid for it will generate a profit; thus, you’ve made money on the appreciated value of the investment. Capital appreciation gets at the heart of most investment strategies.
It’s a primary goal of business decision-makers to increase their shareholders’ equity in the company. Many business leaders are incentivized to grow their company’s market value, hopefully through legitimate and sensible ways, because their compensation’s tied to the performance of the company. Therefore, investors bank on management’s smart decision-making to result in increased prices for their equity in the company. Thus, if you are a shareholder in such a company, capital appreciation can be a significant source of return on your investment.
Dividend Income
Another source of increasing the return on your invested capital is dividends, which typically come in the form of cash distributions to shareholders. Cash dividends are “a mechanism to provide an immediate cash return to a shareholder, as well as a means to attract investor interest in a company” (Simko, Farris, & Wallace, 2017). If a company has sufficient cash flow from operations, it can decide to distribute a portion or all of the earnings in the form of a cash dividend. Most growing companies may opt to retain their cash flow and redistribute it back into the business to continue generating profitable growth opportunities. As a company develops into a mature stage business and its growth options are more limited, then it may elect to issue cash dividends to its shareholders.
Historically, increasing dividends is viewed as a positive indicator for investors that the company is doing well financially and wants to reward its shareholders with cash distributions. Decreasing cash dividends is seen as a negative signal regarding a company’s prospects and may dissuade potential investors from buying equity in the business. As such, a company typically issues a cash dividend only if it is sustainable for the foreseeable future.
When evaluating a company’s dividend, it’s worth noting that the percentage is much more relevant than the actual dollar amount. The dividend paid per share price is known as the dividend yield.
Dividend Yield = Cash Dividend / Share Price
To keep the dividend yield comparable across companies and distribution schedules (e.g., monthly, quarterly, annually), we “annualize” the cash dividend. This means reflecting the dividend payments as the total amount distributed throughout the year. For example, if a company issues a quarterly dividend of $2.00, then we would multiply it by 4 to calculate the expected annual dividend total. In this case, the annualized dividend will be $8.00. We would then divide this by the share price to get the stock’s dividend yield. Let’s say the current share price is $64.00, which would give us a dividend yield of 12.5% ($8.00/$64.00 multiplied by 100; to convert into a percentage).
Dividend-based valuation is one of the oldest and most well-known methods of finding a company’s intrinsic value. In 1938, John Burr Williams, a Harvard-trained economist, wrote extensively about this valuation model in his book, Theory of Investment Value, which provided significant headway for the field of fundamental analysis. Dividends should factor into every assessment of a company or asset. They provide the investor with a future cash flow return on invested capital that we can readily discount back to present value.
Diversification
Holding a single asset means you have all your eggs in one basket. This makes your investment susceptible to any asset-specific risks, such as a natural disaster wiping out a real estate property or a company’s CEO retiring. Counterbalancing or diversifying your portfolio with additional assets will spread out the risk over multiple investments. Diversification is “[t]he reduction in risk due to holding a portfolio of assets that are not perfectly correlated” (Brigham & Ehrhardt, 2017).
Correlation is the degree to which the price of two or more assets tends to move in the same direction. Owning assets that are similarly affected by economic variables carries additional risk. If the overall market swings downward, then both assets are equally vulnerable to negative impacts. Statistical analysis has shown that a portfolio with a range of assets, each affected differently by the economy, will fare much better than one with closely correlated assets.
A perfectly diversified portfolio would own equal portions of every asset available in the market, which would carry with it the risk inherent in the whole market overall. Diversification does not eliminate all risks from an investment. However, it more evenly distributes the risks among an array of assets, thus lowering the risk exposure of any single asset in particular.
Closing Remarks
There are numerous ways to become a successful capital manager and make money investing. However, there is no perfect “one-size-fits-all” approach to choosing your strategy. It’s essential to understand your financial goals and risk tolerance to build your wealth over the long run. By focusing on stable growth opportunities to generate capital appreciation and keeping in mind the benefits of receiving dividends, you will be setting the stage for a better understanding of how your investments are making you money. Remember to utilize diversification to your advantage when selecting assets to invest in, and you’ll help protect your downside. Once you’ve made a reasonable evaluation of your investing approach, focus your future efforts on allocating capital to assets that align with your chosen strategy. Follow these investing basics to get a better understanding of your overall game plan and develop a successful decision-making system.
Enjoyed the read? Subscribe to my blog and spread the word by sharing this article with your circles!
I’d love to hear your take on the subjects we’ve covered in this post. Drop a comment or question below. Let’s keep this conversation going!
Sources
Simko, P., Farris, K., & Wallace, J. (2017). Financial Accounting for Executives & MBAs. Cambridge Business Publishers.
Brigham, E. F., & Ehrhardt, M. C. (2017). Corporate Finance: A Focused Approach, Sixth Edition. Cengage Learning.
