Basic principles that can help you unlock the door to financial independence

At its core, investing in the stock market is a simple activity. That doesn’t mean it is easy, just that the behaviour necessary for success are fairly straightforward. By reminding yourself of what they are and always keeping them in the back of your mind, you can improve your odds of reaching financial independence as you amass a collection of assets that throw off passive income.

Investing key #1. Insist upon a margin of safety

Benjamin Graham, the father of modern security analysis, taught that building a margin of safety into your investments is the single most important thing you can do to protect your portfolio. There are two ways you can incorporate this principle into your investment selection process.

First: Be conservative in your valuation assumptions

As a class, investors have a peculiar habit of extrapolating the recent events into the future. When times are good, they become overly optimistic about the prospects of their enterprises. As Graham pointed out in his landmark investment treatise, The Intelligent Investor, the chief risk is not overpaying for excellent businesses, but rather, paying too much for mediocre businesses during generally prosperous times.

To avoid this sorry situation, it is important that you are on the side of caution, especially in the area of estimating future growth rates when valuing a business to determine the potential return.

Second: Only purchase assets trading near (in the case of excellent businesses) or substantially below (in the case of other businesses) your conservative estimate of intrinsic value

Once you’ve conservatively estimated the intrinsic value of a stock or private business, such as a car wash held through a limited liability company, you should make sure you are getting a fair deal. How much you are willing to pay depends on a variety of factors but that price will determine your rate of return.

In the case of an exceptional enterprise - the type of company that has huge competitive advantages, economies of scale, brand name protection, mouth-watering returns on capital and a strong balance sheet, income statement and cash flow statement - paying a full price and regularly buying additional shares through new purchases and reinvesting your dividends, can be rational.  

Investing key #2. Only invest in businesses or assets you understand. It’s important you recognize your own limitations

How can you estimate the future earnings per share of a company? You’d build spreadsheets, run scenarios and come up with a range of future projections based on different confidence levels. All of this requires understanding how the businesses make their money, how the cash flows into the treasury.  

Shockingly, many investors ignore this common sense and invest in companies that operate outside of their knowledge base. Unless you truly understand the economics of an industry and can forecast where a business will be within five to 10 years with reasonable certainty, do not purchase the stock. In most cases, your actions are driven by a fear of being left out of a ‘sure thing’ or forgoing the potential of a huge payoff. 

From a societal standpoint, these technological advances were major accomplishments. As investments, a vast majority fizzled. The key is to avoid seduction by excitement. The money spends the same, regardless of whether you are selling hot dogs or microchips. Forget this and you can lose everything.  

Investing key #3. Measure your success by the underlying operating performance of the business, not the stock price

Unfortunately, a great many men and women look to the current market price of an asset for validation and measurement when, in the long-run, it simply follows the underlying performance of the cash generated by the asset. The lesson? Focus on that underlying performance.  It’s what counts.

That fundamentals matter seems to be an impossible truth for a certain minority of people to grasp, particularly those with a penchant for gambling. To people like that, stocks are nothing more than magical lottery tickets. These types of speculators come and go, getting wiped out after nearly every subsequent collapse.  The truly disciplined investor can avoid all of the nonsense by acquiring things that generate ever-growing sums of cash, holding them in the most tax-efficient way they have available to them and letting time do the rest.  Whether you’re up 30 percent or 50 percent in any given year doesn’t matter much as long as the profits and dividends keep growing skyward at a rate substantially in excess of inflation and that represents a good return on equity.

Investing key #4. Have a rational disposition toward price

There is one rule of mathematics that is unavoidable: the higher a price you pay for an asset in relation to its earnings, the lower your return assuming a constant valuation multiple. It’s that simple. The same stock that was a terrible investment at Rs.40 per share may be a wonderful investment at Rs.20 per share. In the hustle and bustle, many people forget this basic premise and sadly, pay for it with their pocketbooks.

Imagine you purchased a new home for Rs.5,000,000 in an excellent neighbourhood. A week later, someone knocks on your door and offers you Rs.3,000,000 for the house. You would laugh in their face. In the stock market, you may be likely to panic and sell your proportional interest in the business simply because other people think it is worth less than you paid for it.

If you’ve done your homework, provided an ample margin of safety and are encouraged about the long-term economics of the business, you should view price declines as a wonderful opportunity to acquire more of a good thing. If those statements aren’t true, then you shouldn’t have purchased the stock in the first place. Instead, people tend to get excited about stocks that rapidly increase in price; a completely irrational position for those that were hoping to build a large position in the business. 

Investing key #5. Keep your eyes open for opportunity at all times

Like all great investors, famed mutual fund manager Peter Lynch was always on the lookout for the next opportunity. During his tenure at Fidelity, he made no secret of his investigative homework: Travelling the country, examining companies, testing products, visiting management and quizzing his family about their shopping trips. It led him to discover some of the greatest growth stories of his day long before Wall Street became aware they existed.

The same holds true for your portfolio. By simply keeping your eyes open, you can stumble onto a profitable enterprise far easier than you can by scanning the pages of Financials. 

By adhering to a plan like this, you make sure the money gets allocated to the most advantageous uses first, providing the most utility for you and your family if you run out of cash to save before reaching the bottom of the list.