Things To Know Before You Invest in Stocks (1. Inflation and Investment)

What is Inflation?

You've heard about inflation on the newspaper, television, or from your economics class. Or perhaps you've even heard it from other people complaining about prices going up and up. Inflation simply means the increase in prices of goods.

There are many factors that affects the inflation rate. I will not discuss this further as it is easily accessible in the internet today. But how much it affects us? Below is the Consumer Price Index in the Philippines on the past 10 years:

  Source:  tradingeconomics

We can observe the following:

1. Inflation could reach up 10% as seen in 2008. This kind of inflation is really bad for the economy if sustained.
2. Inflation had fallen recently at around 1%. However, this is mainly due to the slump in oil price which reduces good's delivery cost. This will probably not last long and might even come back with a vengeance (i.e. a spike in inflation like in 2008).
3. Average inflation for the past 5 years is around 3.25%. We could use this as our basis for analyzing our investments.

This means that if you are hiding 1,000,000 pesos under your bed, that money is losing value at around P32,500 on the first year. That is around P2,700 per month. (You will lose less money on the succeeding years since your money has already become smaller.)

A good way to counter inflation are investments.

What is Investment?

In today's culture, the scope of the word "Investment" has already expanded (and perverted) so much it might even include gambling. So always be vigilant when you hear someone offering "Investment" especially the "sure" ones. Even if their intention is true (i.e. not a scam), there's a high chance it's NOT really an investment.

Benjamin Graham and David Dodd came up with a good definition of the word:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.

We shall call investments under this definition "true investments".
This definition has 3 important parts.

1. Promise of principal safety.
2. Satisfactory returns.
3. Thorough analysis.

Promise of Principal Safety

We often hear the phrase "High risks, high returns". But for true investments, high risk does not mean a big likelihood of your capital to disappear. We should not blindly accept higher risk in exchange of higher returns. Otherwise, we are just speculating or gambling.

High risk means there are a lot of things that might go wrong but we have a plan to mitigate them. Mitigating them may result to lower returns, but in the grand scheme of things, the principal should be safe.

Satisfactory Returns

Looking at the other side of the coin, true investment does not mean we should settle for low returns just to make sure the principal is safe.

For example, if a close friend wants to borrow P100,000 from you and promises to pay you back after 4 months with 1% interest. In addition, he is handing you his 1 year old Toyota Altis as collateral (and since he's your close friend, you know that the car is really his and already fully paid). It might seem a satisfactory return as the loan is collateralize (safety of principal) and the return is 3% (better if compared with short term time deposit at banks). But if you look at the inflation rate of 3.25%, that return is low. To make it a true investment, you should ask for 1.25% after 4 months (Yeah, it's just P250 difference, read on).

I'm not saying you shouldn't lend money to your friend, he might really need the cash (and I hope your friendship is not worth less than P1250). But don't treat it as an investment.
Also, "satisfactory" is subjective depending on the person investing. The inflation rate can be a basis but thare should be other factors too. Higher returns should be demanded for other risks.

Thorough Analysis

Now, let's go to the exciting part: Analysis. With thorough analysis, your goal is to have a plan in place to meet the first two requirements.

Let's go again with another example: Dice game.
Supposed you're at a casino and you got P1,200 to play with. There is a simple game of dice cube containing the number 1 to 6, one number on each side. You can play by betting P600 each time. The dealer will throw the dice, if the number is 6, you win and get your capital plus P3,600. If the number is 1 to 5, you lose and get nothing. You can bet again if you want.


As you may have analyzed, the odds is on your side.
1/6 of the time, you can earn P3,600. Which gives you a positive value of P600.
5/6 of the time, you can lose P600. Which gives you a negative value of -P500.

This gives you a total value of P100 for each deal.

(Note: Casinos won't have such deals. They earn from you by letting you play with odds against you, not the other way around.)

Looking again at our criteria:

1. Is the P100 return satisfactory? Definitely YES. Your capital is only P600, giving you 16% in less than 5 minutes.
2. Is there safety of principal? You only have P1,200 so can only play twice. You have 70% chance to lose all you money after playing 2 times. Thus, upon thorough analysis, NO, this is not a true investment.
   You may be feeling lucky as you have 2 chances of more than tripling your money, but that is speculating already.

Oh man, that's already my once in a life time golden opportunity! But if I have P15,000 to "invest" on this game, is it a true investment?
YES, it is. Although there is a possibility of you not winning even once at 25 deals, that would only be around 1% chance ( (5/6) ^ 25 ). If you lose your money this way, the odds may be with you, but the God is not.

The plan of playing multiple times to reduce your risk of losing your principal from 70% to 1% is your mitigation plan which makes this a true investment. This is one form of diversification.

Going Back to Stock Investing

You should choose stocks with good odds (under valued), and buy different companies. Buying only 1 or 2 stocks is like gambling with P1,200 only. The consensus recommendation for diversification is at least 25 stocks.