Knowledge Base

25

Mar

2017

Diaspora Financial Planning IV: Shares

By Cytonn Diaspora     Tags :  



Learn the Discipline You Need to be a Successful Equities Investor

Remember, from our last post that investments are grouped into classes due to their different levels of risk (capital loss), returns (capital appreciation) and liquidity (ease of exit).

As a rule, higher risk assets yield higher returns.

Asset classes are further grouped into traditional and alternative asset classes. Traditional asset classes represent the most common asset classes such as stocks (shares/equities) and bonds (fixed income). Alternative asset classes represent a newer kind of asset class that is often less liquid and not as publicly available as traditional asset classes. Alternative asset classes include private equity and real estate.

Shares represent proportional ownership in a company and are riskier than bonds but have historically offered comparatively higher returns. Shares are further classified by size (large-caps, mid-caps & small-caps) and value versus growth categories. 
Value firms are mature firms that offer stable returns and appear undervalued by the marketplace, while growth firms offer the potential for larger capital gains owing to strong earnings growth potential

Shares are risky. Before you commit your money to investing in shares you need to understand:

  • Your risk appetite: Most investors consider stocks from the perspective of how much they stand to gain. The better mindset is to consider how much they are willing to lose. While risk and reward go hand in hand, your tolerance for risk should outweigh your appetite for reward. How much are you willing to lose?
  • Your Time Horizon: More often than not, those who made gains in the stock market were willing to commit for the long run. Over the short term (days, weeks, months), investing in shares is no better than a coin toss. During the 10 years from Feb 29, 2008 to March 23, 2017, The Nairobi Stock Exchange (NSE) was up 55.6% of the time and down 44.4% of the time. However, over the same 10-year period, shares in the NSE rose by 30.2% in aggregate


Whether you are a short or long term investor also affects how much you pay in taxes. In the US for example, long term capital gains are taxed at a lower rate than short term gains.
  • Your emotions: Often, our emotions get the better of us when investing in shares. Our emotions predispose us to losing in the markets. Beware of these pitfalls:
    • Loss aversion: We often hold on to losing shares in the hope that they will increase in value or to avoid taking a loss. Naturally, this keeps us from selling the losers to cap our losses. It also stops us from considering worthwhile opportunities to buy shares when prices are low
    • When the goal is to buy low and sell high, our emotions set us up to do the exact opposite.
  • Your mind: We are naturally accustomed to patterns of thinking that often fail us when we invest in shares. Look out for these cognitive biases:
    • Representativeness: We often label an investment as good or bad based on its recent performance. As a result, we buy stocks after prices have risen, expecting those increases to continue; also ignoring stocks when their prices are lower than necessary. Past performance is not an indicator of future results
    • Anchoring: We often hold on to beliefs and apply them as reference points for making future judgements. It is common for us to base our assessment of the performance of a stock to the purchase price. It is difficult to adjust our views to new information as a result.
    • Self-attribution: Gains in the stock market often encourage us to think that we are investment geniuses while losses are attributed to external factors. We ignore that luck often plays a big role in our success. This false confidence leads us to continue buying, even when prices are rising.
    • Herding: Often, what investors in the market do influences whether we buy or sell. We buy into hot stocks deep in their rally when prices are high and sell when fear is at its highest; leading to higher losses

Takeaways:

  • The solution is discipline; to commit to buying a little at a time in order to take advantage of cost averaging. If you invest a constant amount each month, when prices are high, you buy few shares but when prices are low, you buy more shares cheaply. Over the long term, you buy more shares cheaply.
  • Sometimes, certain events cause severe dips in the stock market that create buying opportunities.
  • Let someone do the heavy lifting: Picking which shares to invest in is difficult. Thankfully, Cytonn Investments’ experts prepare a weekly guide to the NSE that you can subscribe to here
  • It takes time and skill to invest in the stock markets. You can often get better results by investing in shares through unit trusts and structured solutions. Read more here