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The Fish Tank Theory Of Investing

The Motley FoolThe stock market has a terrible habit of making you doubt your own capabilities. Time and time again, your resolve for investing can be tested to the limit when share prices take a bath. But time and time again, markets also recover.

How you react to market turmoil is a bit like the water in a fish tank. Here’s why.

Many years ago, I was helping a friend move a fish tank from one side of his living room to the other. He assured me that it was not necessary to empty the tank, given that two able blokes could shift the aquarium without too much problem. I nevertheless insisted that we, at least, relocate the fish to somewhere safer. Thank goodness I did.

As we moved the tank – taking one careful step at a time – the water within would crash from one side of the aquarium to the other. By the time we had successfully relocated the tank, there was almost as much water on the floor as there was in the tank.

The episode with the fish tank reminds me of the way that people invest in shares. As investors we will probably be aware that from time to time the market has an awful habit of swinging from one extreme to the other. One moment it’s bullish. The next moment it’s bearish.

Currently, the popular chatter on the market is whether China can successfully rebalance its economy. Tomorrow, the market may find something completely different to worry about. If you are ever short of ideas for things to fret over, just drop me a line. I have a list as long as my arm of things that you can get anxious about.

Meanwhile, the winding down of America’s money-printing activities can fill many fun-filled hours on financial news channels, as analysts pore over each and every sinew of economic data. They think they can second-guess what the Federal Reserve might do next. Good luck to them.

If that wasn’t enough to put worry-lines on your face, you can always sift through the numerous economic reports about our South East Asian neighbours to see how emerging markets in the region might cope with America’s decision to taper.

As analysts continually pass judgement on whether tapering will be good or bad, or whether China’s rebalancing could be bad or good, stock markets will inevitably respond. First one way, then the other – much like the water sloshing from one side of the fish tank to the other.

As investors, you have three possible options. You could, like the fish, sit on the sidelines and wait for the craziness to end. That way you won’t be exposed to any risk at all. But it’s important to remember that returns from the stock market are made up of two separate components – capital gains and reinvested dividends.

Consider a company such as Singapore Technologies Engineering (SGX: S63). Over the last ten years, shares in the defence contractor have risen from a dividend-adjusted price of $1.29 to $3.77. That equates to an annual total return of 11% over the last decade. Just over half the returns have come from capital gains and the rest by reinvesting the dividends. By staying out of the market, you could have missed out on both.

Another strategy would be to time the market. Yes, lots of people like to think that they can do that successfully. However, market timing requires some insight and lots of foresight as to when shares might have hit a peak and when they have reached a bottom.

Thing is, not many people can. Additionally, no one will ever ring a bell at the bottom and top of the market to let you know the right time to get in and out of shares. Consequently, by dipping in and out, you could, like the water in the fish tank, find yourself on the floor as an unnecessary casualty of the move.

The third way is to just stay invested. Only buy shares that are selling below their intrinsic values. That is a good way to help reduce your exposure to risk. The margin of safety that you build in will, unfortunately, not guarantee that things won’t work out badly. But it should give you a better chance for a profit than a loss.

Put another way, if you can buy a 2-dollar bill for a dollar coin, you have a much better chance of making money than if you did it the other way around.

This article first appeared in a SIAS newsletter.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.