The investor’s mindset

The most important thing for active, self-directed stock market investors to have is the right mindset.  Having the right mindset can help you ride out the ups and downs of the market and keep you focused on the things that really matter.

It can also help you take advantage of the manic-depressive nature of the stock market, buying shares when they are cheap and selling them when they are not so cheap.

But building the right investment mindset involves understanding the basics of investing as well as other options such as cash, bonds and property. We need to understand what makes them similar and what makes them different in order to view them all through a single, powerful, overriding mindset.

The safety of savings

Savings can mean many things, but to me, it means putting your money into something where the original amount invested does not change, i.e. there is no capital risk, and you will always get back the amount you invested.

Let’s imagine you’ve been given a £100,000 lump sum.  What are some of your options, assuming you want to save it or invest it for some future purpose?

A savings account

Probably the easiest option is to stick the money into a savings account, which immediately raises the two most important issues in saving and investing: income and capital.

If the money goes into a savings account, there will be an income, although it may be very small.  This income is also variable, with interest rates being changed periodically by the bank or building society.

A quick search online shows me that you could get between 2.5% and 3% on that £100,000, paid either monthly or yearly.

As for the original amount put into the account, it does not change.  If £100,000 is put in, then it will still be £100,000 in 1, 5 or even 20 years, assuming the interest payments are withdrawn.  Not only is the capital safe, but in most cases, there is instant access as well.  If you wanted the money back tomorrow, you could get it.

If £100,000 is put in, then it will still be £100,000 in 1, 5 or even 20 years, assuming the interest payments are withdrawn.  Not only is the capital safe, but in most cases, there is instant access as well.  If you wanted the money back tomorrow, you could get it.

Bonds – Swapping instant access for a higher return

One of the most common ways to get a higher rate of return is to lend your money to a bank, building society or company for a fixed period of time through a fixed-rate bond.  In return for having complete control of your money for a number of years, the issuer will usually pay you a higher, fixed income.

Another quick search of the web tells me that you could buy a 5-year bond with that £100,000 and get a fixed income of 3.5% to 4%, paid either monthly or annually.

Although that doesn’t sound like much of an improvement, going from 3% to 4% means going from an income of £3,000 to £4,000, a relative increase in income of 33%.

So if there is at least a year or two before you need that £100,000 back, you would probably be better off putting it into bonds.

In terms of the capital amount, things are much the same as they were with the savings account.  The bond issuer is contractually obliged to give you back your £100,000 at the end of the term, so the money is very safe as long as you stick with very high-grade bonds.

So let’s assume that you want a higher return and that you really don’t need that £100,000 for at least ten years.  What other options are there for getting a return higher than 4%?

Property investing – Inflation leads to higher returns

Most people understand the concept of using property as a cash-generating investment – as well as a store of value – much better than they do the abstract, casino-like stock market.

However, property and stock market investing have a lot of similarities, and the mindset of a good property investor is very similar to the mindset of a good stock market investor.

Let’s say you want to buy an apartment to rent it out, and currently, it’s on sale for £100,000.  The property already has a tenant who is paying £6,000 a year.  £1,000 of that has to be spent on maintaining the property, so the current landlord has a cash income of £5,000 from this property, which is a yield of 5% on the current price.

If you buy the property, you will have immediately achieved an income 25% higher than the 5-year bond.; £5,000 instead of £4,000.  However, the income is variable rather than fixed.  Even if you have a contract with the tenant, you cannot be sure that they will actually pay the rent.

There is also the risk that when that tenant leaves after six months or so, you will not be able to find a new tenant immediately.  If this takes several months, then your income for that year will be significantly reduced.

So there is quite a lot of risk and uncertainty surrounding the actual income you’ll receive.  However, on the plus side, income from property tends to go up with inflation, which isn’t true of either savings accounts or bonds.

This gives a useful boost to property income returns.  Over ten years, a rental income of £5,000 a year, growing with inflation at 2% a year, would become £5,975 a year.  In contrast, the income from a fixed-rate bond would remain the same over the entire 10-year period.

The longer the time horizon, the more attractive the increasing income from a property investment will become.  For a lot of investors, that growing income outweighs the fact that the income is variable and uncertain.

A growing income is an attractive feature of property investing, but what really sets property apart from bonds is the fact that the value of property also tends to grow in the long term.

Why does the value of property go up?

There are a lot of reasons, but one way to think about it is that the capital value of an investment has an unbreakable link with that investment’s ability to generate cash returns.

The £100,000 apartment costs that much because it produces an income, net of expenses, of £5,000.  If property investors are currently demanding a starting yield of 5% on their investment (assuming they are cash buyers, as you are in this example), then £100,000 is the price that will give them that yield.

If investors wanted a 10% yield before investing in this property, then it would be valued at £50,000 instead of £100,000 (£5,000 income on a £50,000 investment is 10%).

So what will happen as the property’s rent increases over the years, more or less in line with inflation?  Of course, the answer is that the capital value of the property will also increase, more or less in line with inflation.

If we assume the world is a simple and perfect place, then with a £100,000 investment in a property over ten years, with 2% inflation and a 5% rental yield, you would end up with a total income of £54,748 and a property worth £119,509.  In other words, a total gain of £74,257 in those ten years.

Compare that to a 10-year period in which the money was invested in fixed-rate bonds with starting yields of 5%.  In that case, the total income would be £50,000, and there would be zero capital gains.

The property would come out better by £24,257, which is almost 50% better returns than the fixed-rate bonds, even though both investments have the same 5% starting yield.  All of the additional returns come from the fact that property is an (approximately) inflation-linked investment.

This leads to the first part of the investor’s mindset, which is this:

The capital value of an investment is driven, in the long-term, by the cash income it will generate.  Specifically: how much income, when that income is paid, and how much it will grow in the future.  The more income that gets paid, the sooner it gets paid, and the more it grows, the more investors will pay to acquire that income.

On the face of it, property is a much better place to store money over the long term than either bank accounts or bonds.  But it’s not quite that simple.

Capital risk leads to higher returns

The key difference between cash (e.g. savings accounts) or bonds and investments is that there is uncertainty surrounding the capital value of investments.

Although the value of property is likely to go up in the long term in line with inflation, that’s only true over periods measured in decades.  Over shorter time periods of just a few years, the value of property is much more uncertain.

In other words, when the value of an investment is set by the market (the property market or the stock market), there is no way of knowing what the value of that investment will be in the next few years.  We can make informed estimates, but these are unlikely to be accurate.

For example, in 1999, the average house price was £67,478 (according to Nationwide), and in 2004, just five years later, it was £139,027, more than twice as much.  But if you had bought the average house in 2007 for £175,554, then five years later, at the start of 2012, its value would have fallen to £162,722.

One 5-year period leads to a doubling of value, while the other leads to a fall in value.  Neither outcome could have been predicted in advance.  This sort of uncertainty is an inherent feature of both the property market and the stock market (and many other markets too).

It’s only over periods of around ten years or more that property investors can be virtually certain of making a capital gain in addition to their growing income.

So the second part of the investor’s mindset relates to the time horizon:

The capital value of investments is uncertain, and losses can be made even if investments are held over periods of 10 years or more. Therefore, investments should only be made with money that is not required for at least 10 years.  Anything less than that and the chances of a permanent capital loss increase enormously.

Lumpy income and illiquid assets

However, there are problems with property investing.  For example, the income on your £100,000 apartment could be very lumpy – you could end up going six months or more without a tenant.  There could be a fire, and you’d have all that hassle of sorting it out, plus there would be no tenant while the place was repaired.

Another problem is that if you want to re-invest the income back into more property, you can’t (assuming you want to be a cash buyer).  The income in this example is £5,000, so you’d have to wait many years before you had enough to buy another property with.  The same thing applies if, for some reason, you need to sell half your investment; you just can’t.  You can only sell the whole thing or nothing.

Fortunately, solutions to the problems of lumpy income and illiquid investments have already been invented.

Size and diversification can lead to a smoother income

The apartment in this imaginary example is in a block, along with 99 other apartments, all of which are being rented out. In the course of a year, most of the apartments will be fully occupied, but in some cases, there will be apartments that are without a tenant.

Because there are so many apartments in the block, the occupied and empty periods in each apartment tend to average out so that the rental income of the block as a whole is relatively stable and predictable.  In most years, it will go up smoothly with inflation.

This is in stark contrast to the fate of any single apartment, which may be fully occupied for years or may have long periods where it sits empty, producing no income at all.

The only problem is that with 100 apartments, each valued at £100,000, the whole block will cost some £10,000,000 to buy, and unfortunately, you do not have the £10,000,000 required to buy that nice, smooth, growing income.

The wonders of shared ownership

Fortunately for you, somebody has already come up with the idea of fractional, shared ownership.

Imagine that the current owner of the building wants to sell, but he cannot find a buyer with £10,000,000, and he doesn’t want to reduce the price.

To solve this problem, he comes up with a plan to write out 10,000,000 contracts, each of which gives the holder the rights to a one 10,000,000^th share of the entire apartment block.  These contracts are commonly known as ‘shares’, and the current owner prices each share at £1.

So rather than buying a single apartment, with its lumpy income and its ‘all or nothing’ buying and selling characteristics, you can now buy a much smoother income, with much more flexibility in terms of when and how much you can buy or sell.  For example, if at some point you really need to sell just £1,000 worth of the property, then you can, by selling 1,000 shares.

A market for shares

With 10,000,000 shares now available for this apartment block, it would be a good idea if there was a market where investors could exchange shares for cash and vice versa.  So let’s imagine there is one.

This market would work in exactly the same way as an auction, where buyers and sellers come together and attempt to agree on a price in order to make their exchange.

As anybody who has been to an auction will know, the price an item sells for is driven as much by who happens to be bidding as by the intrinsic value of the thing being sold.  The same is true of this market for shares.

• If there are more buyers than sellers on a particular day, then the price is likely to go up on that day.  If, instead, there are more sellers than buyers, then the price is likely to go down on that day.
• If there is someone who desperately wants to buy (for whatever reason), then the price will probably be pushed up, while a desperate seller (again, for whatever reason) will probably see the market price fall.

Liquid markets give rise to speculators

If that were as far as the story went, then perhaps the investor’s mindset would be obvious.

It would be obvious that an investment where the capital value is uncertain in the short-term but is almost certain to go up with inflation in the long term should only be viewed as a long-term investment.

Also, an investment that produces much of its gains by way of cash income should be bought when the income yield is attractive and possibly sold when it is unattractive.

But sadly, that isn’t as far as the story goes.

At some point, the media (i.e. newspapers, TV news programs and, more recently, a huge number of websites) realised that people wanted to know what their investments were worth.

By effectively sitting in the auction room all day long, they could publish second-by-second updates on the price of shares. On the face of it, that seems to be a useful service, but it isn’t.

What it does is drag in speculators who aren’t interested in the underlying asset (apartments in this example). Instead, speculators attempt to predict what other speculators might pay for the shares at some point in the future.

They buy today and attempt to sell shortly after for a quick profit, typically to another speculator looking to do the same.

Without an understanding of the apartment block’s fundamentals (its cash income today and potential growth tomorrow), these speculators have nothing to base their decisions on other than the positive or negative sentiment of other speculators, which is a fickle, volatile and, more often than not, fruitless way to “invest”.

So the third part of the investor’s mindset is:

On a day-to-day basis, ignore the investment media circus and ignore share price movements. Focus on the long-term prospects of the underlying assets you have invested in, rather than whether or not their market value went up or down this week.

Unlike speculators, investors have little or no expectation of when they’ll sell, or whether the shares will go up or down in the short-term. They simply invest in an asset (such as this apartment block) because it is likely to produce a reliable income stream that will grow with inflation over the long term, and the income yield is attractive at the current market price.

In many cases, this means investing after prices have fallen, which raises income yields to more attractive levels. Of course, this is the opposite of what most people do, as most people instinctively want to invest in whatever is already going up in value. But this ability to invest after prices have fallen is what separates the investor from the speculator.

What does all this have to do with the stock market?

Hopefully, it isn’t a giant leap to move from this picture of fractional, shared ownership of a large apartment building to a similar picture, but this time with companies instead of properties.

Instead of an apartment block of 100 apartments, imagine that you have invested £100,000 in shared ownership of 100 companies by buying shares in a fund which tracks the FTSE 100.  The end result is uncannily similar.

With the FTSE 100, we have a large, multi-billion pound asset that pays a reliable stream of cash to shareholders, a stream of cash that has grown for many years and is quite likely to keep growing at or above the rate of inflation for many decades (and perhaps centuries) to come.

In both cases, their growing income streams will drive capital values higher. Eventually, share prices will follow the income upwards, regardless of bull and bear markets and regardless of the actions of speculators who drive short-term market volatility.

Ultimately, investing is about long-term ownership, which, to a large extent, is about picking the right assets to own in the first place and then letting them get on with the job of producing the growing income you bought them for.