Written by Andrew Cassar Overend
14 min read
Last Updated on May 6, 2021
In this article we lay out the most important things to get right when investing, present you the kind of content to expect from the Financial Fortify team, and clarify some important distinctions between certain concepts to kick-start your financial education.
It is indeed ironic that the most crucial concepts you need to get right to fortify your investment portfolio are actually those which are the hardest to observe. These include whether inflation lies ahead, the implications on the value of your currency and how political leaders respond to developments in the economy.
Whether inflation or deflation lies ahead determines the future worth of your saving, how much cash versus assets you should hold, and most importantly, which assets to hold. Therefore, understanding the outlook for inflation is the most important thing to get right to fortify your finances!
Moreover, an understanding of currency movements are important because everything is denominated in currency. Goods are priced in currency. Services are priced in currency. Assets are priced in currency. Currencies are also priced in other currencies (i.e. the exchange rate).
How many euros/dollars/pounds/yen do you need to purchase the new PS5? How many euros/dollars/pounds/yen do you need to purchase a house? How many dollars can you buy with your euros?
Currency is the denominator for everything. This means that a change in the value of the currency will influence the overall price of a good, or service. Currency changes can also affect asset returns. If your home currency is euros, but you hold dollar-denominated assets, then a decline in the dollar relative to the euro will diminish the returns on your dollar-denominated assets.
Irrespective of where you reside or which currency you trade in, the direction of the dollar is a crucial to get right when investing. The dollar is the world reserve currency, meaning that it is accumulated by global Central Banks for their economies to function. This is because because most commodity trade is invoiced in dollars, a large portion of global debt is issued and needs to be repaid in dollars, and the largest and most liquid asset markets are in the US.
The movement of the dollar is crucial to monitor because it is a gauge of the amount of liquidity in the global financial system. If there is not enough supply of dollars to meet demand, then world trade slows and the global economy recedes. In a panic attempt to get hold of dollars, institutions liquidate their assets which causes a crash in the prices of assets, which causes further selling by retail investors. In fact, the asset price crashes witnessed during the Great Financial Crisis and the COVID-19 pandemic occurred because of a scramble for dollars.
Therefore, it is important to understand inflation and the direction your currency is headed because it can have a bearing on the value of your savings, the value of the assets you hold and your ability to buy assets. Being able to identify the implications of a rising and falling dollar is imperative to help you anticipate financial market crashes. This is by no means an easy task, especially because dollar movements are not only tied to forces emanating from within the USA, but also outside the USA.
Policy-makers include Governments and Central Banks. The function of Government is to provide public goods and services and redistribute incomes in an equitable manner. These objectives are fulfilled by adjusting taxation and spending policies.
The role of the Central Bank is to ensure that unemployment is low and prices are kept stable. The conventional tool used by Central Banks to reach these goals is the interest rate. But when the interest rate reaches very low levels and the economy shows signs of weakening, Central Banks resort to unconventional tools to adjust the total amount of money in the economy(/opinion/will-inflation-be-transitory). Although these tools which may work in the short term, they do more harm than good over time.
The bureaucratic nature of Government and Central Banks usually make them very reactive, meaning that economic problems have to emerge before they actually take action. But, the past decade has shown us that policymakers can get really creative with their reactive policies. When investors think that policymakers have no firepower left, they come up with creative ways to reassure investors that they have everything "under control".
This means that policy reactions are quite unpredictable, but a good understanding of how the economy works combined with some grey matter can help us frame the possible outcomes. This is crucial so that we can adjust our investment portfolios for every circumstance.
Because an understanding of inflation and currency dynamics are crucial to effectively manage your finances, our initial articles tackle the widely debated topics of inflation and the true value of currency. We also try conceive the possible policy responses to the various outcomes which lie ahead.
The content we shall publish will be theme-based. Each theme will have a Master Class, in which we present you with a basic understanding of economic and financial concepts which, in our opinion, should be taught at school. These include interest rates, debt, taxes, the time value of money, and even how to value assets. Each Master Class will be complemented with a series of insightful posts on personal finance and investing in different asset classes such as equities, real estate, precious metals and cryptocurrencies, with a particular focus on investment areas which have tremendous upside over the decades ahead. Moreover, we will produce useful tools to help you apply better what you have learned and use to fortify your finances.
As alluded to in our welcome post, we promise to deliver the best content possible. The articles will by no means be academic - the content is produced in an easily digestible manner, with diagrams, infographics and flowcharts where possible to facilitate your understanding. We try to simplify complex concepts as much as possible, because everyone has a right to financially educate themselves. That said, if you already are privy with certain economic and financial concepts, we made sure to include a table of contents in each article so that you can easily jump to the sections which interest you.
With that out of the way, let's start off with some important distinctions you should know.
Value is what something is intrinsically worth. The value of a good, service or asset is subjective, meaning that it may be different for different people.
Contrarily, in the absence of negotiation, price is the same for everyone. It is an objective measure of what needs to be paid to acquire a good, service or asset.
But price may not always be equal to value. When the price is lower than intrinsic value, then the good, service or asset is undervalued. When the price is higher than the intrinsic value, it is overvalued.
Savings are the portion of your income which you set aside with minimal risk. You can easily access your savings whenever needed and the monetary value of your savings do not fluctuate. Because savings are low risk, the return you earn on your savings is also low.
Investing is when you deliberately take on risk in pursuit of higher returns. You can invest in anything you consider a store of value, be it real estate, equities, bonds, cryptocurrencies, precious metals, watches, art, wine etc., with the hope that over time you will earn a stream of income from the investment, or benefit from an appreciation in price. However, investments are more volatile than savings, meaning that they can increase in price or decrease in price.
Another difference between the two is how they are taxed. Savings held in cash are not taxed, but those held at the bank incur a withholding tax (although those earning low incomes do benefit from some allowances). Contrarily, any gains on investments you sell are subject to capital gains tax.
Investing is the process of putting money to work with a view to reap gains in the long term. It involves identifying long term trends, understanding the fundamentals of the asset, and taking a calculated risk which will eventually compound into significant future rewards.
Trading is the practice of generating profits from price changes in assets over a short time period. Traders exploit the reasonably predictable nature of human behaviour to anticipate price movements.
This does not mean that investors blindly buy anything and wait for it to increase in value. Prior to investing, diligent investors ensure that they understand the asset and it's prospects. They also invest in the asset when price falls below its intrinsic value. Long term investors ignore any news which can temporarily cause the price of the asset to deviate its true value. When investing, time is on the investors' side.
Trading is a riskier practice than investing, because any unprecedented shift in momentum can alter the price of the asset against the trader. Traders rely on technical analysis using sophisticated charting software to help them identify good buying and selling levels.
Gambling is the habit of speculating on a future outcome. Asset trades are entered into blindly, without a solid understanding of the asset or an assessment of the asset's risk and future return prospects. People are lured into buying assets either because they witnessed the asset do well historically, because some know-it-all on social media recommended that they purchase the asset, because they fear that they will miss out on exceptional gains, or because they previously made money once doing so and think that they can do so indefinitely.
A macro approach to investing is one which starts from a birds eye view of the economy, and base their investment portfolio on key macro variables like demographics, inflation, interest rates, employment, debt and important political announcements. Micro investors strategize their investment decisions based on industries and companies with attractive valuations and promising developments. In their analysis metrics such as price to earnings ratios, earnings growth, debt ratios, and stock buybacks are used, while close attention is paid to conference calls.
A mix of both macro investing and micro investing would be ideal to reap astounding returns. It is important that the macro narrative is understood well to get the overall direction of a trade right. But more often than not, consensus based trends may be already reflected in the price. This is where micro investing can give an edge to investors who identify investment opportunities in assets at bargain prices.
Value investing is essentially bargain hunting. It is the practice of buying assets at attractive prices relative to their true intrinsic value. The price of an asset can also be compared to its historical valuation and the valuation of its competitors to identify whether it is a good buy. Investors rely on the fact that eventually other investors will realize the true value of the asset and will also invest in the asset, causing its price will rise.
Taken in the context of equities, companies that are well-established and have well-known brand names but are trading at a discount are considered to be a value play. Because they are well-established, value equities are considered to be less risky than growth investments. Value investments do not have growth as a priority, but usually reward investors with periodic dividend payments.
Real estate may be a good value investment when an attractively priced property is found. Examples of value stocks are Johnson and Johnson (JNJ), Pfizer (PFE), and Walmart (WMT).
Growth investing is the practice of buying assets which have the potential to generate strong returns. The term is usually used in the context of investing in companies that grow faster than the rest of the market, meaning that the bulk of the cash flows of these companies will be realized in the distant future. Instead of paying dividends, these companies will reinvest their profits in the business to keep growing.
Everyone's favourite example of a growth stock is Tesla. Other assets with huge growth potential include cryptocurrencies and rare collectibles like baseball cards.
Buying assets with huge growth potential at undervalued prices would be the ideal scenario.
Those who are optimistic on the prospects for an asset are said to be "bullish". It follows that a bull market or bull run occurs when the market experiences a strong and sustained appreciation in prices.
Contrarily the bear symbolizes those who are pessimistic on the outlook for risky assets. The formal definition of a bear market in equities is when prices drop by at least 20%. An equity market correction is a downward move in prices which is larger than 10% but less than 20%. In the crypto world however, prices tend to exhibit more volatility, meaning that they fluctuate more aggressively on a daily basis. Thus, corrections in cryptocurrencies tend to be around 20-30%, while major crashes generally occur when these drop by 50% or more.
Going long essentially buying an asset with the expectation that its price will be higher in the future.
If you buy 100 shares of Apple, then you are long 100 shares of Apple stock.
An asset is sold short when you bet that an asset which you do not own will experience a decline in price.
If you short 100 shares of Apple at £120 each share, then you borrow 100 shares from your broker and bet that the price of Apple shares will be lower than £120 at a future date. At this future date if the price is indeed lower than £120, then you can buy the 100 shares at a lower price. If the price of Apple is higher than £120, then your broker may ask you to deposit additional money into your account to ensure you are able to afford the 100 shares at the higher price. This is called a margin call.
Relax, these terms are not referring to your body weight! =]
These concepts are generally terms coined by analysts to predict the performance of an asset in the future. It is used in the context of portfolio construction. An underweight recommendation for a stock means that the asset under question is expected to underperform the overall market, so it should make up a lower proportion of your portfolio. An overweight recommendation means that the stock is expected to outperform the market, so it should make up a higher proportion of your portfolio. That said, we personally think that you should not base your investment decisions on analyst recommendations. Always do your own research prior to investing - remember, invest, don't gamble!
As confusing as these terms may sound, they are very easy to understand.
Inflation refers to an increase in prices or a decline in the purchasing power of the currency.
Deflation refers to a decrease in prices or an appreciation in the purchasing ability of the currency.
For instance throughout the last three months of 2020, the average rate of inflation was -0.3% in the Euro Area, meaning that prices fell by 0.3% from the same period of 2019.
If inflation describes the rate of increase in prices, disinflation is when each increase in price is lower than the prior increase. This means that while inflation remains positive, it trends downwards.
Consider the 3 years: 2018, 2019 and 2020. In 2018, Euro Area inflation was 1.8%. In 2019, inflation remained positive but decelerated to 1.2%, while in 2020 it continued to decelerate to 0.4%.
Hyperinflation is when price increases accelerate to a point when prices go hay-wire and inflation becomes uncontrollable. Price rises of more than 50% per month are not uncommon during hyperinflation.
Recent episodes of hyperinflation happened in Venezuela which started in 2016, with inflation reaching as high as 130,060% in 2018. At one point, the price of 1kg Barilla pasta in the US was $2.50, while in Venezuela it was $301.50. From 2016 till the time of writing, prices have increased by 53,798,500%.
Stagflation is a situation when prices are rising, but economic growth and employment growth are weak.
Reflation refers to a pick up in employment, output and inflation following an economic slowdown.
The following is some jargon which you may hear people cite on financial media:
When you hear this phrase, beware. It will be probably someone defending his/her thesis on why an event which did not happen in the past should happen now. But in reality the following saying is a more accurate depiction of reality.
Although asset prices cannot be predicted with certainty, people's behaviour is predictable. An analysis of historical episodes show some similar features which could have easily been identified by those living at the time.
This phrase suggests that markets have efficiently absorbed all present and future information available on an asset at a given time and reflected this information in the market price. Because investors are forward-looking, if they anticipate a positive event to transpire in the future, they reflect this optimism by buying into the asset today.
This follows from the previous saying, namely that investors price in all information. When optimistic new information comes to light, even if it is not official, prices tend to respond instantaneously. But if the future event does actually happen, the good news would have already been built into the price of the stock, and institutional investors use this as an opportunity sell their shares and book a profit.
Investors use this phrase to reassure themselves that policymakers will always come to the rescue when economic turmoil occurs. Central Banks will always use its monetary tools to counteract a financial asset sell off. Governments will always spend their way out of recessions.
This phrase is frequently cited when there is a sudden drop in asset prices which can be an opportunity to enter a position or continue building a position at bargain price. This is easier said than done, because nobody knows when the dip will come to an end.
Thank you for reading our first article :) If you wish to join us on our journey to personal success, sign up now to make sure that you don't miss anything!
The only way you can have any likely chance to reap financial freedom is by understanding how to effectively manage your money and how to invest. Unfortunately, we are not taught the basics of financial management in school. But do not use this as an excuse to not self-educate yourself. We will do our utmost to guide you in any way possible.
Remember, if you put your mind to it, and believe in your capabilities, everything is possible. All you need is the willingness to learn, the effort to take action, the ability to remain diligent, and the capability to keep an open mind.
Recent PostsWhy it has become more challenging for younger generations to become wealthy and what they should do about it Understanding the economics of the global energy crisis The only investing guide you will ever need Are you rich? Is it possible to have too much savings? Is the reflation trade over? Investment opportunities for 2021 and beyond Is the Consumer Price Index a good measure of inflation? Best investments for inflation protection