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Becoming a competent investor

Guarding Wealth: There are several sources of financial advice for beginning investors, 
or investors looking to learn more

As a columnist for Grainews and Financial Post, I am frequently asked what it takes to learn to invest in stocks, bonds and other financial assets. There is a core of knowledge that every investor needs.

Books

Inspirational personal finance books. The Wealthy Barber is the best of this breed, but this is investing lite. The books say if you skip lattes and invest coffee money, you can be rich. Much of it is true, but this will not help you to judge risks in stocks, calculate bond returns or judge mutual funds by their management cost and asset characteristics. You need to know valuation methods and risk assessment, accounting and statistics. Skip the inspirational stuff.

Financial technique books. This group cleaves into two schools: the fundamentalists and the technicians.

Books on fundamental value come in many flavours, from searches for stocks by such ratios as price to earnings. Much of this material is good, but each book’s theory must be tested. You can learn a lot of valuable things, but much of this material has a critical flaw. Most authors say they mine data to develop their theories. Those theories are predictive models that link several variables. The best fit of leading indicator and subsequent stock value becomes the theory. Then the theory is backtested against the same database. The author of each theory says it works, which is not surprising given that it’s the same data from which the theory was developed.

A different stream is deductive from first principles, not inductive from fitting trends to each other. The best of the deductive genre is Benjamin Graham’s The Intelligent Investor edited by Jason Zweig. It is the fundamental work in the field of investment analysis.

Fundamentals

Technical analysis follows wiggly stock, bond, commodity or other price patterns, tracing out lines of price movements by the hour, day, week, month, etc. There are numerous variations from patterns that incorporate daily or other price ranges, moving averages, moving averages of convergence and divergence, and another tracery which attempts to link sun spots to stock prices and plot all of that on graph paper. The time intervals tend to be days and weeks, for over periods of decades most stocks and averages rise. There’s less to analyze in the long run. For short periods of days and weeks and sometimes months, technical analysis presumes to incorporate everything known about a stock or a commodity. The downfall is that new information changes the line, so what was known is no longer the whole story.

There are said to be 100,000 asset indexes published every day. It is absolutely certain that some of the time, one can find a relationship between, say, the price of pork bellies and the daily moves of a Chinese auto parts stock. There is no meaningful way to relate these two things. Any theory which seeks to extrapolate a trend based on one or the other is doomed to fail. Now that you know what technical analysis is, consult it, as many professional investors do, but give it wide berth.

From the Country Guide website: Are you marketing or speculating?

Macroeconomics. Nassim Nicholas Taleb, a mathematician, scholar, and sometime options trader, has said that macroeconomics is a “fantasy.” Those who believe in it delude themselves that it has value, he says. One can modify his view and take macroeconomics with a grain of salt. The serious investor needs to take a course or read a few good books on macroeconomics to get an understanding of central banks, how taxes affect output and consumption, and what makes up gross domestic product. This is essential information for the investor.

Accounting. If you are going to read financial statements, you need to know why an income statement is not a balance sheet, how costs can be capitalized, how shady managers can manipulate earnings, how companies can shift costs and earnings to make the most of tax opportunities in various jurisdictions and how noncash items like goodwill are incorporated into accounts.

Mathematics. You need algebra to calculate ratios and extrapolate the present to the future. You need a little calculus to test propositions that sales will grow at an accelerating rate and make you rich. Math can show you how to graph two variables on a plane, three as a surface moving in a three dimensional space, and four, five, 10 or 20 variables that you cannot visualize.

Statistics. The best way not to be lied to by statistics is to know how they work. Normal bell curves are not characteristic of financial markets. Instead, the distributions are call log normal, Poisson and other names, each of the about 80 curve shapes reflective of different data distributions. Learning this discipline is a must for investors.

Capital markets. You need to know how bonds relate to stocks, how stocks can be structured as common or preferred issues, the workings of stock options such as puts and calls, how bonds are ranked by quality, bond rating and default probabilities, how stocks and bonds trade, how commodities trade, and price patterns set or limited by asset characteristics. If you see a stock trading at 100 times next year’s earnings, your sceptical antennae should bristle. The stock has become a kind of fashion investment statement and is ready for a crash. If a stock is trading a just two times forward earnings, it may be because investors think it of little value. If someone wants to sell you a bond with what he says are “investment grade” characteristics and a 20 per cent annual interest rate, you should know that somewhere, somehow, there’s a scam. Learn how markets work and you’ll not be bait.

Economic history. The stories of great traders, the winners, the losers, fabulous ripoffs like the 17th century tulip bubble, histories of central banking, origins of paper money, the invention of inflation-adjusted bonds in 13th century Venice and more are fascinating and very instructive. As the Spanish philosopher George Santayana said in The Life of Reason, a five-volume book published in 1905, “Those who cannot learn from history are doomed to repeat it.”

 

Suggested titles:

Macroeconomics: Campbell R. McConnell has written several economics textbooks published by McGraw Hill. It’s a place to start.

Accounting: Howard Schilit and Jeremy Perler, How to Detect Accounting Gimmicks & Fraud in Financial Reports. It’s hilarious, instructive and indispensable.

Mathematics: Mark Ryan, Calculus for Dummies. As digestible as the subject can be.

Statistics: Robert A. Donnelly Jr., The Complete Idiot’s Guide to Statistics. Cheap and easy going.

Capital markets: Benjamin Graham, The Intelligent Investor, ed. Jason Zweig. The classic book on the subject brought into the 21st century by a fine financial journalist. This is a must.

Economic history: Charles R. Kindleberger, Manias, Panics and Crashes: A History of Financial Crises. This is a superb work, often cited by other authors and analysts. See also, Jeremy Siegel, Stocks for the Long Run, 4th ed., 2007. Siegel, a widely respected professor of finance, demonstrates that stocks, if held for periods of decades, have handsome and even dependable long run returns.

 

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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