Q: I am extremely concerned about my exposure to the share market given the experiences of this week.  Why is the share   market so volatile when the fortunes of companies do not change so rapidly? What steps should I take given the current climate?

 

A: In 1934, Warren Buffett’s mentor, Benjamin Graham, published “Security Analysis”  this became the seminal work for serious share market investors. The principle of the work was those seeking to invest should draw a distinction between investment and speculation. Graham’s three ideas principles of investing were as follows:

  • You should look at shares as part ownership of a business.
  • Market fluctuations provide an opportunity to profit from folly rather than participate in it.
  • Prepare for a worst case scenario by including a margin of safety in your portfolio.

When you buy shares, you buy a portion of a company and share in the fortunes of that business. The value you place on that  business should be based on your view of the prospects for the business to grow and generate income both now and into the future.  You determine what price you are prepared to pay or accept, not the market.

Speculators lose sight of a key point: the share market facilitates the trade in ownership of companies. The price paid on a given day is a base function of supply and demand; the price someone is prepared to buy a stock and the price a counterparty is prepared to sell a stock.  The market is often driven by sentiment, not logic. Provided you are comfortably with the future prospects of a company, daily fluctuations in the value of the stock should be seen as an opportunity to gain advantage from the market; Buy when you feel a stock is cheap and sell when you feel the stock is expensive.

Be conservative with your earnings outlooks for particular stocks.  Make sure the business can whether a future financial storm.  Building a margin of safety in your portfolio means you prepare for tougher times.  Hold sufficient emergency funds that you will not be forced to sell a stock that you believe in if your circumstances were to change.

Diversify your portfolio into a range of sectors and companies.  A word of warning, 42% of the composition of the Australian All Ordinaries index in concentrated in the top 6 stocks by market capitalization; 4 banks, a miner and a telco. This concentration has increased markedly since the GFC as investors seek companies paying dividends.  A portfolio that is diversified by buying the 4 major banks is not a diversified portfolio!

If you do not feel comfortable assessing the future prospects for a company and determining its fair value, seek advice from a Financial Planner or a Stock broker. Managed funds provide a low cost and effective mean of diversifying your portfolio and outsourcing the management of a portfolio to investment professionals.

Whether you choose direct equities Or managed funds, always invest in accordance with your appetite for risk, consider your time frame for investment and do not participate in the folly of speculation.

Empirical studies have demonstrated that moving in and out of markets in an attempt to time market swings often does more damage to long term wealth creation than staying the course based on your long term objectives.

Markets rise and fall. We have seen this before and we will see it again.

Follow Andrew on Twitter @AndrewHeavenFP. This article was originally published in The Australian