Thursday, September 10, 2009

How to be a better Investor part I

When you learn do drive a car there are some thing you have to know – like steering wheel, brake, clutch and how to use them. Why should investing be any different?

Having a firm grip on fundamentals will help you when in doubt. Let’s look at the following, one post at a time.

• Time value and Compound interest
• Asset allocation
• Industry dynamics
• Reading Financial Statements
• Valuation and Market capitalization

Time value of money
In an inflationary environment -Money is hand today is better than tommorow.Inflation as you know reduces the purchasing power of money. It’s happening all the time just that we tend to forget it and don’t adjust our returns for inflation. Some people buy gold as hedge against inflation, China is buying base metals.anyways.

There are lot of concepts and formulas to calculate the future and present value of money but I will spare you the punishment!

Compound Interest

Understanding compound interest is at the basis of understanding investing.
Let me ask you this - If I gave you the choice to buy Manhattan Island,NY for $24 would you do it ?
And a guy called Peter Minuit actually did just that. Sounds like a great deal! but the catch is that the year was 1626. Now suppose he had put this $24 bucks it in a saving account giving 8% compound interest - it would be worth $ 151 trillion today. That’s compound interest for you.

A company estimated to compounding its earnings by 21% over 10 yrs is better than a company doing the same@ 20% for 10 yrs. Simple huh!. Point to remember is -Effect of compounding is small for a small number of periods, but increases as the number of period increases.

Estimates cuts both ways though – at times the rate of growth can be fast so that the risks one take takes while buying the stock may not be risks at all if the growth forecasts are approximately correct. On the other hand if the rates are precisely wrong one can loose a lot of money – very quickly too.

As an investor you must look at what a company has done in the past because as in life, stocks need to be understood backwards but lived forward. You can use a scientific calculator or FVIV tables to make these compound interest calculations simple. One easy way is the rule of 70 or 72 (which ever is divisible)

Rule of 72
I use this approach to eliminate lot of investment candidates, you can use it too!

This is not accurate but handy tool to guesstimate – about how soon the money will be doubled. Let’s say Infosys declared an EPS of Rs 100 this year and expects to earn 200 in year 2018 - At what rate is it compounding?

The answer is 72 divided by 9(no of yrs to double) = 8% so if this is true I may be better of investing in savings accounts giving me 8% annually since its risk free. However the opposite is true if the company is able to do it in say 4 yrs (18%). Seems farley obvious but this is often forgotten by investors and institutions alike especially when they try to chase the latest fad.

I will discuss about asset allocation in the next post – although volumes of books have been written on each of these topics but you can better off from the completion by this knowledge, if you are still awake that is! 

What do you think, would love to know your thoughts.