A Time to Buy
This is a good time to buy stocks now, right, because the stock market is down? -- R.Y., Charleston, S.C.
A: Right! When the overall market tanks, even the stocks of great and growing businesses can fall -- often below their intrinsic value. But do your research first, and make sure any company you invest in is built to last.
This pandemic is dealing harsh and sometimes fatal blows to lots of businesses. Dig deeply into any company you're considering investing in, since you'll essentially be buying a piece of it – and its future. Study its annual and quarterly reports; assess its cash and debt loads, its profit margins, cash flow, and the growth rates and trends for such measures.
Warren Buffett recommends asking the following questions when evaluating stocks:
- Can I understand the company?
- Does it have sustainable competitive advantages?
- Is the management honest and competent?
- Is the price attractive?
Can you explain how Uber apparently only raised $8.1 billion when it went public last year, when the company was valued at about $75.5 billion? Why didn't the initial public offering (IPO) raise $75.5 billion? -- T.M., Spokane, Wash.
If Uber had offered all of its shares to the public market in its IPO, it would have collected around $75 billion. But as companies typically do, it offered only some of its shares for sale to the public, with insiders maintaining majority ownership -- and control.
If a company needs more cash later, it can always sell more of its shares on the market via a "secondary offering." Companies can also change their number of shares over time by issuing more shares or by buying back shares.
Whenever you calculate or are presented with investment returns, they're often in nominal terms, and not real ones. "Nominal" vs. "real" is an important distinction to understand.
A real return is one that has factored in inflation (and sometimes fees and taxes). For example, the S&P 500 has averaged annual returns of close to 10% over many decades, but that's a nominal average. Remember that inflation was at work over that period, and that historically, inflation has averaged roughly 3% annually, though at times it has been much higher or lower. To arrive at the S&P 500's long-term real return, you simply subtract the 3% inflation rate from the nominal average return of 10%, getting 7%.
Such differences have meaningful ramifications in our financial lives. For example, if you invest $5,000 per year for 30 years and average 8% gains, you'll end up with about $612,000. That's pretty good, but prices don't remain the same over time -- they tend to increase. That $612,000 may sound great today, when things we're used to buying cost what they do today -- but if inflation averages 3% annually over those 30 years, prices will be, on average, about 2.43 times what they are now. So a $50 restaurant meal might cost $121.50, and a six-pack of paper towels that goes for $8 today may cost around $19 in 30 years. Your $612,000 won't go nearly as far then as it would today.
If you model the growth of your money using a real growth rate of 5% instead of 8%, that $5,000 annual investment for 30 years grows to $348,800. So you may actually end up with that $612,000 -- but it will have the buying power of around $348,800 in today's dollars.
These considerations are important for savings, too, not just investments. For example, if you're earning 2% interest for many years on your savings, but inflation is averaging 3%, you're actually losing purchasing power over time. You can look up historical inflation rates and find inflation calculators at sites such as InflationData.com.
My Dumbest Investment
Buying and Selling Errors
My dumbest mistake was dumping what was, at the time, 100% of my money into shares of Advanced Micro Devices about 3 1/2 years ago. I failed on both the buying and selling. I was completely undiversified, which was stupidly risky, and even though it all worked out, I didn't hold on to the shares like a good Fool would, and I didn't realize all the gains I could have. The stock rose sharply after I sold. — Gregory S., online
The Fool responds: It's always risky to put all -- or most -- of your eggs in one basket. Even the most well-known and well-regarded companies can end up in big trouble or out of business. Blockbuster, Chrysler, Delta Air Lines, General Motors, Lehman Brothers, Pan American World Airways, RadioShack, Texaco, Toys R Us, Washington Mutual and F.W. Woolworth are just a few examples. Distribute your money across 10 to 20 companies — and then keep up with their progress. Or, opt for a simpler way to profit from the stock market -- investing in one or more low-fee, broad-market index funds.
Also, as you noted, think twice before selling, as great businesses -- and the U.S. economy -- are likely to keep growing over the long run. Shares of microprocessor and computer graphics chipmaker Advanced Micro Devices advanced by double and triple digits in 2018 and 2019, respectively.