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Hi Reader,
Welcome to the 8th edition of the Stockstartr newsletter. In today's edition, you'll learn what you need to stay wealthy and why you should know what type of investor you are.
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Fundamental
Getting Wealthy vs Staying Wealthy
There are many ways to get wealthy, from high-paying jobs to starting a business venture. The web and social media sites are filled with content on achieving riches. Staying wealthy, however, isn't much talked about. So how do you do that?
Staying wealthy isn't much discussed and might be more difficult than getting wealthy. We all have heard stories of lottery winners, athletes, and investors who had it all and lost it just as easily. For the majority of the population, it costs more energy to stay rich than to get rich.
Imagine you found a way to riches and have 10 million in the bank. You have family and friends who ask for hand-outs, and you give it to them. You go on expensive vacations for the experience. You acquire a new social circle that owns bigger houses and faster cars and want that, too.
Giving in to all these expenses drains your money in the bank fast. Staying wealthy is financially surviving. It allows you to gain more wealth over time, putting the money in the bank at work instead of purchasing status symbols.
When you survive and put the money to work, you will experience the magical returns of compounding. To achieve this, you have to appreciate the following 3 things:
- Live below your means: you have financial gains from your wealth-producing assets. Your expenditures should be lower than your financial gains. Only then will you grow your wealth.
- Become financially unbreakable: have enough cash on hand during financial hardship. During strong upward market movements, such as bull runs, putting all your money into the market is tempting. Keep 10% of your capital in cash. Say you earn 1% interest on cash and 14% during the bull run. The gap is 13%. It looks huge, but if you are forced to sell during a strong downward movement, the money can't compound. Forced selling will hurt more than a 13% gap.
- Plans aren't exactly going to plan in the real world: many investors forget to consider room for error. Their investment bets weren't successful because it required them to be exactly right, but they were mostly right.
The S&P 500 averaged a yearly return of 10%. Many will start using this percentage to calculate how much money they have in 20 years. What if the index only averages 6% for the next 2 decades? You should be fine with that outcome, too. Plan accordingly!
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- Be optimistic and paranoid about the future: you must have optimism about the future. The odds in the long term are in your favor. Nevertheless, there is likely misery to come between now and the future.When we look at the American gross domestic product (GDP), it has grown over time. If you zoom in, you will see the hick-ups, and it wasn't a smooth ride. The paranoia will keep you aware of the misery in between. It harasses you against getting wiped out in the stock market.
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Glossary
Accounting Principles
Accounting principles are guidelines, and rules companies must follow when reporting financial data. Standardized terms and methods make it easier to analyze financial data. The US uses the Generally Accepted Accounting Principles (GAAP), while Europe and most other countries use the International Financial Reporting Standards (IRFS).
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Practical
The Auditors Report
The Security and Exchange Commission (SEC) requires public companies listed on the American Stock Exchange to audit the financial statements in annual reports. The quarterly reports are free from audits.
An external auditor is an independent accounting firm that checks the work of the firm's accountants. The public company has the freedom to choose one themselves. Many prefer one of the following four: KPMG, PwC, Ernst & Young, or Deloitte.
Auditors give opinions based on the going concern basis of the company. Going concern is the assumption that the company isn't heading for bankruptcy and will stay in business for the coming years. Upon reviewing the company's financials, they write a letter describing their findings and informing the board of directors. The annual report includes the letter, available under item 8, just before the financial statements.
The audit report contains some boilerplate texts, but you can easily get the gist of it. You only have to look for a couple of things, really. The letter has a general outline:
- Opinion on the financial statements.
- Basis for opinion
- Critical audit matters with a description of the matter
- Auditor's signature
The section on opinion on financial statements includes one sentence that says if there is malpractice or not. "In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the company at [date end period] and [date beginning of period] ." It basically means to the knowledge of the auditor, it all checks out. Typically, you'll find yourself reading this sentence.
Sometimes, the auditor reports a critical audit matter. The auditor wants to alert investors to less transparent financial statement numbers. Often, it is about brand valuations or other intangible asset valuations by the board. Another example is when third-party companies are hired to determine borrowing rates.
How the management of the company acts when critical audit matters are pointed out tells you a lot about how the company is run. As an investor, you want management to take care of the critical audit matter for transparency's sake. So, you look for the same critical audit matter in next year's annual report. If it is solved, it won't reappear. If it is addressed again, then management hasn't taken action and hasn't the investors' best interest at heart.
The signature closing the letter indicates who the auditor is and since when they are the auditor.
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Principle
Know what Type of Investor You are
Great investors are self-aware, know themselves through self-reflection, and act accordingly. Don't confuse famous here with great. Not every famous investor is self-aware.
It is generally believed that there are 2 categories of investors: active and passive. Speculators are not in either category as they aren't considered investors. They fit in another group of market participants.
Passive investors only do one thing: put their money in a growing index fund like the S&P 500. They have average market returns and are at peace with that. They accept that they won't outgain the S&P 500 by analyzing stocks.
It costs them almost no time and enjoys an average of 10% (average of last 100 years). It is so easy and simple. Many market participants (speculators and investors) feel the need to put more time into it to justify this simple "trick."
This brings us to the second category, the active investors. This category consumes more time and effort to invest in companies with a high probability of higher-than-average returns. From the outside, it looks doable. Every quarter, many stocks have a +20% movement. However, it requires timing the market and is only for speculators.
Active investors focus on longer-term investments, looking for companies that grow faster than the economy to outperform the index. They are dedicated to learning and spend many resources to beat the index.
It sounds great to do better than average. Nevertheless, most will perform worse. Fund managers, for example, experience social pressure, which turns into bad decisions and impatience. Active investors need a framework to make consistent decisions.
Whatever type of investor you are or want to be, keep the following in mind. Don't get persuaded by anyone. Passive investors may be attracted to more gains like sirens in the water. Think about who you decided to be and follow this rigorously. Active investors should periodically reflect on whether they get any better at outperforming passive investors. If they don't, then active investors should consider becoming passive. There is no shame in this, and better for your wallet.
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No investing advice is given at any moment. The newsletter is purely for informative purposes only.
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