We have a strange way of thinking of stock as something different from everything else you can put your money on. We think of homes and cars as something physical, but when we talk about stock we don’t see how they are something physical as well. I’m talking about company stock – not livestock although in general they should be thought of in the same way, sans the ethical aspect of livestock being alive.
Rule 1: Stock is nothing different from anything else you waste money on.
Company stock is no different from milk, or at least it should not be any different. It is an investment that you get something out of – be it then a potential to get money, to quench your thirst or to put a roof over your head. When you buy milk, you probably have a barrier price that you wouldn’t go over. Say if the milk cost you $500 per bottle you probably wouldn’t buy it. But how about if the milk yesterday cost $500 but today it only costs $300 – would you buy it? Perhaps, if you reeeeaally needed milk, but in general it would still be way too expensive for most of us. Why do people then look at historical values for stock when making their decision? I know you as an intelligent reader wouldn’t do this – but most people who invest in stock look more at historical value than what could affect the company, not to mention not even try to understand what the company really does.
Warren Buffett once said
“There are all kinds of businesses that Charlie and I don’t understand, but that doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the individual investor should do. “
and I think that is the most fundamental thing people forget – if you don’t understand how milk is made into yogurt, then look into dairy firms that only do Milk and see if you find something worth investing in that you understand. Don’t put your foot into a bucket of yogurt.
Rule 2: Don’t buy things in a black box wrapped inside a shiny bag. If you don’t understand what you are about to buy – don’t buy it!
Sadly, rule number 2 not only applies to stock but more and more to housing as well. You would think that people would think more when they invest 20+ years of their lives (i.e. take a mortgage) and make the biggest investment decision they will ever make in their lives. Instead this investment decision is made sometimes in 15 minutes on the spot without going through the merchandise in detail. I know, because I made my decision in 15 minutes. There is a historical reason this. Before everybody built their own houses or at least had to know how to build a house – nowadays we don’t need to understand that anymore, so instead we rely on beauty issues such as decoration and the colors on the walls instead of looking at what repairs are required, where the house is located or what the life cycle cost of the house is (e.g. energy consumption). Of course beauty issues matter but there is more. See the “Stand up economist” below for a short summary so you understand how people and money don’t mix:
The thing that separates stock from other investment objects, such as apartments or milk is that, they are more complicated (or so we tend to think). People don’t mind not understanding stock or think stock is something difficult that they should not understand so they don’t. And because of that, market fluctuation is more volatile than anywhere else. This explains that some stock is worth more than what the company could potentially make when selling their products to the world’s entire population (Y2K anyone?) or that some stock is worth less than all the assets the company owns.
The latter is called Graham’s Net-Net rule and is one of a handful of golden rules that Benjamin Graham has given a name to (BTW Grahams is the person Buffett refers to more than often). The idea is that if the stock is worth less than the liquidation value of the company then it is worth buying because the risk is nearly null that you lose your money. Remember rule number 1: Stock is nothing different from anything else you waste money on. So a company stock is also only an ownership of a company and its assets. More concretely Graham’s Net-net value states that you should compare the current assets of a company minus its total liabilities to the value of the stock. Say for instance that the company has current assets (assets that are easily converted into cash) that are worth $20M and its total liabilities are $8M then its net-net value is $12M ($20M-$8M). If its stock is worth $10M then you are basically paying $10 for every $12 that you buy! These stocks are more seldom in modern days – but especially in the situation we’re living today, there are and will be more companies that fall into the category – all thanks to market sentiment and fluctuation.
Rule 3: If somebody gives you money for free with no risk or obligation – take it! (If money is what you’re into…)
To put it all in more simple terms, Buffett has summed it up (at the age of 21) in one often quoted sentence:
Be fearful when others are greedy. Be greedy when others are fearful.
This all comes down to market stupidity (see the video above). People do what others are doing so nobody every wins. The only way to win is to do the opposite of what people are doing and not listen to others. Especially not banks – because the only thing they are after is your money. Never listen to people that give you advice (which by the way goes for me as well! 
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To summarize it all: Be smart and think for yourself – don’t let others make decisions about your life.
To read more on the subject or see what the real experts think follow the links below:
The Intelligent Investor by Benjamin Graham.
Tim Ferris’ questions to Warren Buffett
