There are many useful sayings in the stock market that can guide you as investor. But not all sayings are created equal. Some sayings may sound logical and yet turn out to be harmful to the common investor. In particular, here are two sayings which I feel should be ignored or avoided by the Foolish investor. “High risk, high reward” The saying above – “high risk, high reward” – may imply that big returns in the stock market are only possible through making a high risk investment. This train of thought may sound logical at first. But chasing higher risk investments…
There are many useful sayings in the stock market that can guide you as investor.
But not all sayings are created equal. Some sayings may sound logical and yet turn out to be harmful to the common investor. In particular, here are two sayings which I feel should be ignored or avoided by the Foolish investor.
“High risk, high reward”
The saying above – “high risk, high reward” – may imply that big returns in the stock market are only possible through making a high risk investment.
This train of thought may sound logical at first. But chasing higher risk investments may not always provide you with a matching high return.
In fact, Warren Buffett once said:
“I don’t try to jump over 7-foot hurdles: I look for 1-foot hurdles that I can step over.”
Said another way, Buffett’s not actively looking for investment situations that bring with them unnecessary risks. Instead, it’s quite the opposite. He would prefer his investments to be as simple as possible.
Thing is, seeking lower risk investments has not stopped Buffett from generating a track record that is the envy of the investment world. In his fifty years (and counting) as Chairman of Berkshire Hathaway Inc. since 1965, Buffett has led Berkshire’s book value per share to grow at a compound annual rate of 19.4%.
For some perspective, Buffett’s returns easily outpaces the long term total return of 8.4% delivered by the SPDR STI ETF (SGX: ^ES3) since inception in April 2002; the SPDR STI ETF is a proxy for Singapore’s stock market barometer the Straits Times Index (SGX: ^STI).
With that in mind, I would rather side with Buffett’s wisdom on this one.
“What goes up, must come down”
The saying above implies that stocks that rise will eventually come back down. It can also imply that you should sell once your stock goes up since it “must come down” at some point.
The phrase sounds witty and clever, but following it may also cap your long term returns significantly if you are not careful.
Pan-Asian retailer Dairy Farm International Holdings Ltd (SGX: D01) can be a nice example. Shares of the company have booked a nice 158% in capital gains in the five years between 2004 and 2008.
But if the whimsical investor decided to sell the company in 2008 on the basis of “what goes up must come down,” he or she would have missed out on further gains from Dairy Farm from 2008 to today.
The costs of selling too early would have been big considering that Dairy Farm’s shares would have turned every dollar invested in it at the start of 2004 into four dollars today.
The problem with the saying may lie with the focus on the stock’s price alone.
As you can observe in the chart below, the business performance of Dairy Farm – the growth in its free cash-flow and dividends as well as the evolution of its balance sheet – had improved steadily over the decade from 2004 to 2014.
Source: S&P Capital IQ
The end result was that shares of Dairy Farm had followed its business performance – and not the flimsy saying of “what goes up, must come down” – from 2008 onward even after its stock had gained 158% in price from 2004 to 2008.
With Dairy Farm’s experience, I know what I would rather do when I’m faced with a stock that has a climbing price – I’d focus on its business. If the odds are that the firm can grow its business materially in the future, I’d be happy to buy to hold its shares, regardless of what its price had done over the past few years.
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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 contributor Chin Hui Leong owns shares in Dairy Farm and Berkshire Hathaway, Inc.