Personal finance skills part 2
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Personal Finance Skills Part 2
Investing
Investing is a way of saving money by investing it in financial instruments such as futures, mutual funds, stocks, or bonds and potentially earning higher returns than saving the money in a bank account. Investing is an effective way of building your wealth in the long run. Investing is great and educational, and it is one of the most equal hobbies out there. An employee on a construction site, a truck driver, or a teacher, might be a better investor than a master of finance, with PhD degree, who has studied investing for years. According to Esa Juntunen, author of the book viisas sijoittaja and a Master of Business Administration says that if you need a degree to invest, you are making things too difficult for yourself. Investing is not, as a rule, a matter of knowledge or skill, but a sport in which one’s own and others’ emotions play a key role. (Juntunen 2023)
Juntunen argues, that during his over a decade-long investment journey, he found that he didn’t need books, people, or articles on how to invest properly. He needed someone to tell him what not to do.
For some, investing is considered gambling and your success relies on pure luck, but in reality, if you as an investor act like a gambler, investing will turn into gambling. Unfortunately, in surprising situations, the investor starts to behave in an irrational way, like a gambler. We don’t understand the basics and the probabilities, we take too many risks, we are too impatient or we run after a quick money. (Juntunen 2023)
The stock market is a central pillar of capitalism. Companies go public to secure funds for expanding their operations. Economic growth relies on the growth of business profitability, as the income generated by firms forms the basis for both private consumption and government spending. Exchanges are markets where supply meets demand. If the demand is high, the price of the stock goes up, and the other way around. The idea of the stock market is to allocate capital efficiently from those who have it to those who need it. According to Warren Buffett, an investing guru, the idea of the stock market is to channel money from the impatients to the patients.
Since the world is connected, the price of a single share and the overall stock market index depends on the prices of all possible investments in financial markets, both nationally and globally. As a result, it’s challenging to predict how individual shares or the entire stock market will move. Unlike real estate, stocks can be easily and quickly turned into cash, whether you want to sell a small or large number of shares on the stock exchange. This makes stock market investment unique and advantageous compared to other types of investments. (Mueller 2018)
Investing in the stock market helps companies to raise money by offering their shares for sale and it gives the investor an opportunity to have a slice of that company’s profits.
The magic of building up wealth on the stock market comes from compound interest, where the interest builds up on the previous interest. Unlike simple interest, compounding multiplies money at a fast rate. Compounding interest periods are times when the interest is added to the account. It can be compounded annually, quarterly, semi-annually, monthly, daily, or on another basis. Let’s say you invest 100 euros per month from your 20s to 60s, with an average of 4 % interest annually. After 40 years your investment value is 151550 € with only 54100 € of principal investment. (Fernando 2023)
Although it might be tempting to enter the markets, for most of us it is hard to choose the right instruments to invest in from the hundreds of different stocks, funds, and bonds. The instruments work differently and understanding the whole picture is difficult.
Risk
It is safe to say, that return and risk go hand in hand. The higher the risk is, the higher the potential returns are. The right balance between risk and return varies based on several factors, such as an investor’s willingness to take risks, their years until retirement, and the possibility of recovering any lost funds.
Time is a critical factor in determining the right balance of risk and reward in a portfolio. For instance, if an investor can commit to long-term equity investments, they have the potential to recover from market downturns and benefit from market upswings. Conversely, if an investor’s time frame is limited to a short period, the same equities pose a higher risk.
The risk-return tradeoff is a crucial aspect of every investment decision made by investors, and it is also used to evaluate their entire portfolio. When assessing their portfolios, investors consider the risk-return tradeoff to determine if their holdings are well-balanced in terms of concentration and diversity. They analyze whether the mix of investments exposes them to excessive risk or provides the desired potential for returns. Investments like cryptocurrencies, options, penny stocks, and leveraged ETFs are considered high-risk, high-return examples. In contrast, a diversified portfolio helps mitigate risks associated with individual investment positions. For instance, although holding a penny stock may entail high risk on its own, if it’s just one position in a larger and diversified portfolio, the overall risk exposure is minimized.
There are different ways to evaluate and calculate risk. Stock volatility refers to how much a stock’s price changes over time. If a stock has high volatility, it means its price goes up and down a lot, which can make it riskier to invest in. On the other hand, if a stock has low volatility, its price remains more stable, making it a safer investment option. Investors often look at stock volatility to understand the potential risks and rewards of investing in a particular stock.
A beta is a tool used in fundamental analysis to measure how much an asset or portfolio’s price moves compared to the overall market. The market itself has a beta of 1.0, and stocks are ranked based on how much their price fluctuates compared to the market’s movements. For example: A stock has a beta of 0.6%. When the market goes up by 1 %, the stock goes up 0,6 % on average.
Alpha ratio is a measure used to assess how well an investment performs compared to its expected returns. It helps investors understand whether an investment has outperformed or underperformed its predicted performance. A positive alpha indicates the investment has performed better than expected, while a negative alpha suggests it has underperformed. Essentially, alpha helps investors determine if a particular investment has delivered superior returns based on its level of risk and the overall market’s performance. (Chen 2023)
The risk-return tradeoff is a principle in trading that connects the level of risk to the potential reward. According to this, if an investor is willing to take on higher chances of risk, they have the potential to earn higher profits. The more risk an investor is willing to take, the greater the potential for higher returns.
Investing metrics
Before the next part of the essay, it is important to go through some keywords related to investing, in order to evaluate the investment.
EPS:
EPS stands for “Earnings Per Share.” It’s a financial measure that indicates how much profit a company has earned for each outstanding share of its common stock. EPS is calculated by dividing the company’s net earnings (profit) by the total number of outstanding shares of its stock.
EPS is a key indicator used by investors, analysts, and financial professionals to assess a company’s profitability on a per-share basis. It provides insights into how efficiently a company is generating profits for its shareholders. EPS is often used in conjunction with other financial ratios and metrics to evaluate a company’s performance, compare it to peers, and make investment decisions. Companies with higher EPS are generally considered more profitable, but it’s important to consider EPS in the context of the industry, market conditions, and other relevant factors.
P/E Ratio:
The Price-to-Earnings ratio is a valuation metric used to assess the relative value of a company’s stock. It’s calculated by dividing the market price per share (Price) by the earnings per share (EPS). Again, EPS represents the company’s net income divided by the number of outstanding shares, indicating how much profit is generated for each share.
The P/E ratio provides insights into how much investors are willing to pay for a company’s earnings. A high P/E ratio suggests that investors have high expectations for future growth, often indicating a higher premium placed on the company’s earnings potential. Conversely, a low P/E ratio may indicate lower growth expectations or undervaluation.
It’s important to note that the P/E ratio should be used in conjunction with other metrics, as a standalone ratio might not provide the complete picture. A high P/E ratio could mean that investors believe that the stock price will go up in the future or, that the company is extremely overvalued and will drop in the future.
Dividend yield ratio:
The Dividend Yield ratio helps investors understand the income they can potentially earn from an investment in a company’s stock through dividends. It’s calculated by dividing the annual dividend per share by the current market price per share and then multiplying by 100 to express it as a percentage.
(Dividend Yield = (Annual Dividend Per Share) / (Current Market Price Per Share) * 100)
So, if a company pays an annual dividend of $2 per share and the current market price of its stock is $40 per share:
Dividend Yield = ($2) / ($40) * 100 = 5 %
This means the Dividend Yield is 5 %. It indicates that for every dollar invested in the stock, an investor can expect to earn about 5 cents in dividends over a year.
P/B ratio:
The Price-to-Book ratio is used to evaluate the relative value of a company’s stock in comparison to its book value. It’s calculated by dividing the market price per share by the book value per share.
P/B Ratio = (Market Price Per Share) / (Book Value Per Share)
For example, a P/B ratio of 1.2 means the stock’s market price is 1.2 times higher than its book value. This could suggest that the market is valuing the company at a premium over its accounting value.
Investors use the P/B ratio to assess whether a stock is overvalued or undervalued based on its book value. A P/B ratio below 1 might indicate the stock is trading at a discount to its book value, potentially suggesting a good value. However, context matters, as industries with higher intellectual property or intangible assets might have P/B ratios greater than 1.
Quick Ratio:
The Quick Ratio, also known as the Acid-Test Ratio, is used to measure a company’s short-term liquidity and its ability to cover immediate financial obligations. It’s calculated by subtracting the value of inventory from the sum of current assets (like cash, and accounts receivable) and then dividing that result by current liabilities.
(Quick Ratio = (Current Assets – Inventory) / Current Liabilities)
The Quick Ratio provides insight into how well a company can meet its short-term financial commitments without relying on selling its inventory. A higher Quick Ratio suggests better liquidity and a stronger ability to handle short-term obligations.
Current Ratio:
The Current Ratio is another liquidity metric that assesses a company’s ability to pay its short-term liabilities using its short-term assets. It’s calculated by dividing current assets by current liabilities.
(Current Ratio = Current Assets / Current Liabilities)
The Current Ratio offers a broader view of a company’s short-term financial health by considering all current assets, including inventory. Like the Quick Ratio, a higher Current Ratio indicates better short-term liquidity and a more comfortable position to meet obligations.
Understanding these metrics together gives us a clearer view of a company’s health and potential. Remember, there’s no one-size-fits-all approach. A combination of these metrics, along with other research, helps us make informed decisions and build a balanced investment strategy. (Osakesijoittaja)
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