Investing in stocks is somewhat of a risky game for those who don’t understand the nature of the business. In the short term, equity prices are highly unpredictable, there are few if any traders who have made a sustainable long-term career out of trading equities independently in the short term without blowing up. Even Goldman Sachs’ star traders are known for eventually tripping up and crashing out of the game when they leave the bank.
In the long term, however, the investment game is more predictable. If you spend your time doing your research, you can attempt to limit your risk although even the most rigorous due diligence sometimes fails to miss fraud by management or other factors that are unknown to the investor.
Moreover, even if you spend weeks researching an investment opportunity, there are only two factors you can ultimately control with an investment. The first is the entry price and the second is cost.
Two factors you can control
The margin of safety principle, invented by the godfather of value investing Benjamin Graham, will help you effectively manage the price factor. Investing is more art than a science, and even the most rigorous analysis will never give you an accurate company valuation. Markets are erratic and unpredictable; it is impossible to put an exact precise value on any public company's shares.
A company may have an intrinsic value of $40 per share, according to your calculations, but there’s no guarantee this target will ever be reached. In fact, you may be the only investor who believes the shares are worth this much; other investors may have a higher price target or even a lower price target and thus, the shares may trade over or under your estimate of intrinsic value. Therefore, the margin of safety is necessary. If you believe the shares are worth $40 each and buy at a 50% discount to intrinsic value, even if the market only awards the company’s share price of $30, you are still up 50%. There are other factors to consider here such as time, changing fundamentals and dividend income but this is basically how the margin of safety works and how it can tilt the odds of making a successful investment in your favor.
The second factor investors can control is the cost of investing. ETFs have become popular recently due to their low annual management fees in comparison to active managed mutual funds. ETFs and trackers generally charge around 0.5% per annum in fees compared to active funds, which can charge up to 2.5%. The additional 200 basis points in fees per annum can really add up over time. For example, if the market returns 9% per annum for the next 10 years, an ETF or tracker would turn $1,000 into $2,260 including fees. On the other hand, the active fund (assuming it kept track with the index and did not over or underperform) would turn the same $1,000 into $1,967 including fees. This is a very basic example, but it illustrates the point.
Costs are not just limited to fund fees. Platform charges, commissions and taxes are all other costs the investor must deal with. Controlling these costs should be the priority of every investor. You can’t control equity market returns in the space of a year, but you can control how much of your returns you must pay out in fees, taxes and trading costs. As the example above shows, even if these expenses are just 2% per annum, they can severely curtail your returns over the long term. Taxes can be even more damaging.
The maximum capital gains tax rate in the U.S. is 20% if you consider the fact that the equity market returns around 9% per annum on average, this figure is significant. Limiting your tax bill by investing for the long term and not selling shares -- following in the footsteps of Warren Buffett (Trades, Portfolio)-- will not only reduce your workload as an investor but it will also significantly increase your long-term returns.
Conclusion
To maximize your investment returns, keeping an eye on costs is almost as important as picking right stocks. It’s more important than picking the right stocks if you just buy ETFs and tracker funds.
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