As a public-school-educated, young adult who owns multiple businesses, financial literacy is something I've had to educate myself about. I’m forever surrounded with generational Z noise telling me the hottest cryptocurrency investment or the latest non-fungible token (NFT) to buy.
When it comes to investing, I want to make sure I am making intelligent decisions, not just following the herd.
Also read: How to invest in Australia by buying stocks
With the help of some very successful investors, I've put together three ways to tell if you're actually investing or just rolling the dice.
1. Know the difference
“An unprecedented number of people (are) treating the stock market like a casino,” said famous American investor Warren Buffett.
“Many young investors don’t understand the difference between investing and gambling,” said Tony Kynaston, the millionaire Australian investor who is the creator of the QAV Investing Podcast.
Having been a professional investor for 30 years (allowing him to retire from the workplace at 43), Kynaston said that the difference comes down to a basic mindset.
“Successful share investors only buy stocks when they are at a discount to their true value,” he said. “They believe the market will eventually catch on, the price will go up, and they will be able to sell at a profit.”
Gamblers, on the other hand, just buy something in the hope that it will go up. Their decisions aren’t based on science or discipline. Quite often they are based on hype and the fear of missing out.
So how do you calculate the true value of an asset?
Kynaston likes to use a cafe analogy.
“If you were buying a cafe, and had to work out what you’d be willing to pay for it, you’d try to figure out what the business was actually worth."
"How many customers is it serving on average every week? What are their margins? How much competition do they have in the area? How much are they paying on the lease of the property and how long is left on the lease? How old is the coffee machine they are using and when will it need to be replaced?
"You’d ask these questions to work out how much profit the business would generate in a year and, from there, work out what you’re willing to pay for it.
"When we are buying stocks, we are actually buying a share in a business, so the thinking needs to be similar. It’s common sense. But when it comes to investing, common sense often flies out the window.”
If you can’t work out the value of something today, then it isn’t investing, it’s gambling.
And, as Kynaston said: “Not many people on the rich list made their money through gambling.”
2. Have a strategy and stick with it
Another common mistake young investors make is to invest without a strategy. They invest based on tips from friends or what they hear is 'hot' on social media.
A good investing strategy will have been tested over decades and proven to work across the normal market cycles. It will tell you what to buy, when to buy it, how much to pay for it, and, importantly, when to sell it.
“Once you have a set of rules to work with, it takes emotion out of the equation,” Kynaston said. “You just follow the rules, year in, year out, and ignore the hype.”
Buffett often talks about the importance of knowing your “circle of competence”, which means knowing an industry well enough that you can determine the right businesses to invest in, and not trying to invest outside of that competence.
3. Only sell when you have to
Ok, so if we buy when something is trading at a discount to its true value, when do we sell it?
If we sell it too soon, we might not maximise our profits. But if we sell too late, the same is also true.
Like Buffett, who famously wants to hold his stocks forever if he can, Kynaston said that he only sells when his strategy forces him to.
“I don’t believe in rebalancing or taking profits just because of gut feel. I will only sell something when it breaches one of the rules of my strategy.”
Some of these rules include the price falling 10 per cent below what he paid for it, or bad news coming from the company, like the sudden resignation of the CFO.
He also doesn’t believe in holding something just because he believes in it.
“If a stock I like tanks because the market abandons it, I’d rather put my money into something where it can work for me. I don’t let my ego get in the way. I can always buy it again later when it recovers.”
The bottom line is that understanding the difference between investing and gambling, and having a proven strategy, are fundamental to long-term success as an investor.
This reminds me of another Buffett quote: "Only when the tide goes out do you discover who has been swimming naked.”