Three Stock Market Investing Truths I Used to Hold

Over the last few months, I’ve had the opportunity to observe seasoned investors up close. This has significantly changed the way I view investing in the stock market. Here’s what I used to hold true, what I now believe and why my thinking has evolved.

You Can’t Beat the Market

Actually, you can. With one caveat: You can beat the market if your investment strategy is based on a scalable, successful framework. To illustrate, devout disciples of Benjamin Graham’s value investing approach believe that over time a stock will gravitate to its intrinsic (or true) value. As a result, investors of this strategy look for temporary market dislocations and security mispricings to take advantage of embedded investment returns. The fact that a company is a market leader or has strong competitive advantages makes the investment much more compelling.

I’ve also found that investors who beat the market tend to behave differently from others. These folks employ a great deal of discipline, patience and always keep the risk-reward trade-off top of mind. One of Warren Buffet’s most popular sayings is “Be greedy when others are fearful, and fearful when others are greedy”. Would you pay $0.80 for $1.00? My guess is you would. But how many of us would have the patience to wait for that $0.80 to become a $1.00? Not many. Every time the market has crashed, massive opportunities emerge – but people remain fearful. That’s the reason why most people didn’t buy Amazon in 2009 and lost out on making 10x their investment. Investing when others thought the world was falling apart takes discipline, patience and a deep understanding of the risk-reward trade off.

I believe that if you can learn a new language, or learn to code, then learning to invest and beating the market is possible. This doesn’t mean you shouldn’t consider index funds – it just means that it is possible to beat the market – you just have to be willing to put the time in understanding how to it successfully.

Only Upside Matters

Wrong again. Consider this: If you had to choose between two investments – Investment A and Investment B – where Investment A could return 100% and Investment B could return 50%, which investment would you choose? Probably Investment A – and I don’t blame you. Ok, now we have some new information so let’s rethink this a bit. There is a strong possibility that you could lose all of your money in Investment A but only lose 10% in Investment B. Now which one would you choose? You’d probably chose Investment B.

Successful investing isn’t just about upside, it’s understanding the range of a stock’s potential movement, and the expected value of a security. Great investors spend a tremendous amount of time figuring out their true downside. This includes historical pricing levels, comparable analysis, draconian scenarios and talking to other investors. These shared insights factor into the buy price and help great investors find securities with more upside and limited downside.

Calculating downside risk isn’t easy – its a multi-disciplinary skill that requires assessing macroeconomic, political, and other extraneous risk factors, in addition to the financial requirements.

Index Funds – Always

That’s only partially true. It’s prudent to have 80 – 85% of your portfolio in index funds. The balance of your portfolio should be in higher returning securities. And you don’t have to go to Harvard or Wharton to make sound investments. There are plenty of smart, sell-taught individuals who have made great investments before, and in some cases, have made careers out of it. For example, the Lumber Liquidator short, which hedge funds have made millions from, was surfaced by a 25 year-old PhD dropout. Another example: Scion capital (a massively successful multi-billion dollar hedge fund) was founded by a physician who learned to invest by reading forums. He was known to write book summaries as he was an avid reader of fundamental value investing books. The point of these anecdotes is to show that dedication and thoughtful research can find things institutions can miss.

I believe that individuals have an advantage because they invest in relatively inefficient parts of the market. For example, its difficult for most institutions to invest in small-cap stocks because of their need to put a large chunk of money to work. Because of this, these stocks are less efficiently priced and offer interesting opportunities. Warren Buffett has said on-record that he could guarantee 50% returns annually on an investment pool smaller than one million dollars.

As I read more investment rationales on Instavest and learn from my successes and mistakes, I find myself intrigued by the people that pick winning stocks more often than not (shown by their win-ratio). Not everyone is going to be a stock market winner, but it’s quite an opportunity to be able to see how a select few investors invest and to improve myself as an investor.

Zain Allarakhia is Co-Founder and CTO of Instavest, a collaborative investment network.