Do you buy stocks based on what your friends, relatives or stock analysts recommend? Prudent investing is a mindset and philosophy of investors. Successful investing is accumulation of shares in a good business. The business grows or deteriorate on a daily basis but the share price tickers will fluctuate on a daily basis more than the actual business condition. This is what Ben Graham coined as Mr Market will visit day in day out and present a different price to the investors. Mr Market can be rationale on certain days and behave irrationally on other days.
You need to weave this together with the mindset to support your temperament and individual skill sets. You need to pass the sleep-at-night test, with a sound investing process and compliment with the investor’s temperament, psyche and skill sets. Then can only the investor sleep at night without the worry of short term changes in price of his stocks.
Prudent investing involves fundamental analysis of the business, sleep soundly at night and adopt a mix of investment philosophies to curtail his investment strategy. Prudent investing involves studying the business, the management and potential future growth story, study the financial statements and determine the intrinsic value of the business and have the right psychology. The crux of prudent investing is to buy businesses selling below its intrinsic value. It focus on fundamental analysis instead of using technical analysis. Prudent investing has no regards to price fluctuations and set a long time horizon to hold the stock of the business.
During the crisis in 1997, 2000 and 2007, a lot of Singaporeans lost their entire life savings in the stock market and they brand investing equivalent to gambling. Investing is not risky if you know what you are doing. It is just like driving, if you know the rules and has been on the road, you will know how to reduce the risk to minimum. You need to have the comprehension, courage and conviction of the business which you are going to acquire and will not deviate from your decision in trying times. In the academic finance literature, beta is a measure of volatility of a security. High beta equates to high risk but high beta presents better buying opportunity. For instance, ABC Company has intrinsic value of $25 but is trading at $20, this may seems attractive but if the stock drops further to $10, the stock is more volatile but will become a more attractive investment due to larger bargain.
Investment needs a business approach to evaluate the company. There is a business behind the stock price, business takes time to flourish and fundamentals do not change overnight, unlike a stock price. Business has its business cycle, it will achieve stellar growth during its infant stage and reaches a plateau slow growth in its mature stage. Stock price is not equivalent to the value of the business. In short term, the stock market is a voting machine and long term is a weighing machine. Price of the stock does not represent the value of the business in the short term. In the long term, both price and value will converge.
How prudent investing works
The share price of a company increase when investors expect stronger future earnings. Prudent investors look for future growth driver which will increase the share price of the stock. Future growth drivers of a company include expansion of business, increase in product varieties and innovating the products.