Stock Market Investing Part 2 Five Essential Stock Market Principles | John Colley | Skillshare

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Stock Market Investing Part 2 Five Essential Stock Market Principles

teacher avatar John Colley, Digital Entrepreneurship jbdcolley.com

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Lessons in This Class

10 Lessons (34m)
    • 1. Stock Market Investing Part 2 Five Essential Stock Market Principles Introduction

      2:28
    • 2. Five Essential Stock Market Principles

      2:06
    • 3. The Power of Compounding

      5:37
    • 4. Compounding The Rule of 72

      2:28
    • 5. Why is Liquidity important?

      4:25
    • 6. What do we mean by Volatility?

      3:27
    • 7. Why is Diversification important?

      4:17
    • 8. The Time Value of Money

      4:24
    • 9. Five Essential Stock Market Principles Summary

      3:15
    • 10. Stock Market Investing Part 2 Five Essential Stock Market Principles Summary

      1:20
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About This Class

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This is the second part of a multi part course on Stock Market Investing.

The purpose of the course is to empower you to understand how to invest in the Stock Market for the long term.  This is not "get rich quick" nor will you find stock recommendations or advice on making money.  This is for students who are looking to understand the importance that long term investment can make to your wealth and your retirement.

I have been an investment Banker for over 30 years and started my career as a Stockbroker at Hoare Govett in the City of London in 1988.  This is the expertise and experience I am sharing with you.

In this course we are starting with the basics and introducing the Stock Market, its components and its players.

These are brief descriptions of the videos in this course.

Five Essential Stock Market Principles -  Introduction

In this section we are going to discuss five essential stock market investing principles:

  • The Power of Compounding and the Rule of 72
  • Why is Liquidity important?
  • What do we mean by Volatility?
  • Why is Diversification important?
  • The Time Value of Money

The Power of Compounding

In this lecture we explain the importance of compounding, a mathematical principle which Einstein called the 8th wonder of the world.  Using two examples we demonstrate the impact that compounding and exponential growth can have on your investment returns and how Warren Buffett came to be worth $18 billion.

The answer by the way is a combination of the power of compounding and time.

Compounding: The Rule of 72

This is a very easy to use technique for estimating the time it takes for an investment to double in value.  We explain how to use it in this lecture.  Tuck this away in your investing tool box and bring it out when considering your investment strategies.

Why is Liquidity important?

Liquidity is a critical principle in finance and investing.  It applies to Stock Markets, Company Accounts and your own personal finance as we shall explain in this lecture.

What do we mean by Volatility?

Volatility is a measure of the amount by which the price of a security fluctuates compared to movements in the market. It is frequently used as a measure of risk; the more volatile the stock price, the higher the company’s risk. We discuss the applicability of volatility to risk and introduce the Capital Asset Pricing Model, beta, which is used to measure volatility and equates to a measurement of risk in the model.

Why is Diversification important?

Diversification is a risk management technique for reducing risk while potentially improving returns.  We discuss different types of diversification and explain both its benefits and drawbacks to the Stock Market investor in this lecture.

The Time Value of Money

The Time Value of Money concept is at the core of finance and is critical to Stock Market Investing.  We explain why a dollar today is worth more to you than a dollar tomorrow and show you how to calculate both future values and present values using the concept of discounting.  This is an introduction and we will be exploring time value and discounting in more detail in future lectures.

Five Essential Stock Market Principles - Summary

This lecture summarises the main learning points in this lecture.  These are the foundation stones of becoming a successful long term Stock Market investor and it is important that you understand these before moving on.

In the Class Project, I have set a number of multiple choice questions to reinforce the learning in this course.

Enjoy the course

Best regards

John

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Digital Entrepreneurship jbdcolley.com

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Transcripts

1. Stock Market Investing Part 2 Five Essential Stock Market Principles Introduction: Welcome to stock market investing pot to find essential stock market principles. Hello and welcome to part two of my stock market investing course five, essential stock market principles. My name is John Kali and I am an investment banker with over 30 years experience. I have been around the block a few times and I have seen a lot of this stuff live in action, starting with when I joined whole cuvette in back in 1988 as a trainee stockbroker. This series of stock market investing courses is designed to empower you to have the confidence to increase your wealth over the long term by having the confidence to invest in stocks and shares. This is the second course in the series, and we're going to discover the power of compounding and the Rule of 72. Why liquidity is important? What do we mean by volatility? Why diversification is important? And the time value of money. This course is aimed at beginners upwards, even if you have some investing knowledge, you will find helpful concepts, principles, and learning points to make you a better investor. Please note, this is not a get rich quick course. This course will not contain investment recommendations or stock tips. It is focused on the skills and knowledge you need to become an investor, not a speculator. At the end of this course, you will have grasp some of the key principles of stock market investing. And these are very important as we go forward with further parts of this course. This course project is a short five question multiple choice test to see how much of the information in the course you have assimilated. The answers are in a Word document which you can download from the project section. I hope you will find this and all the subsequent parts of this course informative, engaging, and easy to follow. I look forward to working with you through the extensive knowledge base that we are going to cover with the goal of helping make you an investor. So let's get started. We have a lot to cover. So let's just jump straight into the course and get started enrolled in the course now, and I'll see you in the next lecture. So that's stock market investing part to the essential stock market principles. And we're now going to crack on with the course. 2. Five Essential Stock Market Principles: We're going to take a look at five essential stock market principles. In this section, we are continuing to lay the foundations of our stock market investing knowledge. We're going to examine five stock market principles which are fundamental to understanding how to invest and grow your wealth over time in the stock market. The first of these is the power of compounding. We will explain why this is a central strategy to successful long-term investment. The Rule of 72 shows you how you can quickly calculate the impact compounding returns. When we discuss liquidity, it has several meanings. The ease with which you can trade in markets without adversely affecting prices or cash. The ultimate form of liquidity is an important part of your portfolio strategy. We'll discuss the importance of liquidity and how it can affect your investments. Volatility, often associated with risk, needs to be understood. We explain why using volatility as a measure of risk may not be valid. And we explain why we challenge accepted stock market investing, orthodoxy. Diversification, not keeping all your eggs in one basket, has its pluses and minuses. These are explained in the lecture. The time value of money is a critical concept to finance in general and stock market investing in particular. We explained present values and future values in this important foundational lecture. These are important foundations and successful long-term investors understand these principles as you will need to. So that's a brief introduction to the five essential stock market principles we're going to cover. 3. The Power of Compounding: I want to talk to you now about a really important investing principle. And that is the power of compounding. As a definition. Compounding is the investment process whereby interests is credited to an existing investment amount as well as to the interest or many paid. In simple terms, you earn interest on your interest. And this magnifies returns over time to a surprising degree. Let us examine two examples to demonstrate the power of compounding. First of all, the grain of rice and the chessboard. A king who loves chess, challenge to Sage to a game and offered him any reward the sage could name if he won. The sage, who was also a good chess player for just a few grains of rice in return. But in a particular manner, the king was to put one grain on the first square, two grains on the second square, and doubled it up for every consequence square. As you can see, there are 64 squares on the chessboard. The king, excepted. Following the rules of exponential growth. The king soon realized his problem. On the 20th square. He would require 1 million grains. On the 40th square, he would require 1 billion grains. And on swear 64 and I can't even say this. He would require 18 and then 3, 6, 9, 12, 15, 18 zeros. I didn't how many billions or trillions that is, this is approximately however, 210 billion tons and enough to cover the entire surface area of India, one grain thick. Mathematically, this is T subscript 64 two to the power of 64 minus one. For my second example, let me ask you a question. How many times do you need to fold a 0.1 millimeter thick paper before it reaches the moon. If you're not quite sure the distance to the moon is 3,840,400 kilometers. Just to help you. A few 100 folds, maybe a few thousand. Well surprisingly, the answer is 42. The first 36 folds cover just 1% of the distance, and the remaining 99 percent of the distance is covered by the last six volts. While our brains are used to thinking in a linear fashion, the power of compounding can make an enormous difference to investment returns. The key to making combining work for you is to allow time to play its role. The first few years make little difference, but once it reaches a tipping point, it will grow substantially. They have often. Even Warren Buffett has made most of his wealth off to his 60th birthday, age 30, his net worth was 1 million or $9.3 million in today's money. If he had retired age 60, his worth would have been 11.9 million. But today he's worth over 81 billion. So you can see the enormous power that this has had. The formula is a very simple one. The future value FV equals the present value PV times 1 plus I, which is the interest rate to the power of n, which is the number of compounding periods, IE the number of years. An example of $1 thousand over ten years and 20 years compounding at 20% is surprising. Over ten years, the $1000 goes to 6,192. But over 20 years, at 20 percent growth, it goes to 38,338. If you consider annual returns at 15 percent growth, your wealth will quadruple in 10 years. At 25 percent growth, It will go up nine times. And at 5850% growth, It will increase by 58 times. That is the power of compounding. You can work this out for yourself using a compound interest table such as this one. They've actually very simple to set up an Excel or just use the simple formula I've provided you with above. The key to making compounding work for you is patients don't get greedy and cut corners, don't take unnecessary risks. Let the mass and the power of compounding work for you over time. The best advice I have for you is to start early. So that is the power of compounding. It is one of the most important investing principles you can learn. Einstein called it the eighth wonder of the world. And it's something you must factor in to all your investment strategies whenever or with how much money you are starting. 4. Compounding The Rule of 72: While we're on the subject of compounding, I want to talk to you about the Rule of 72. The Rule of 72 is a very useful tool for understanding the power of compounding. You can also use it to apply it to your and investments in enables you to easily calculate the time it takes for an investment to double in value by dividing the interests percentage per period, which is usually yes. You can calculate approximately the number of periods required for the investment to double. This can also be used with your annual rate of return on your investment portfolio. Let's look at a simple example. If we invest $100 with compounding interest of 9% per annum, the Rule of 72 gives 72 divided by 9 equals eight years for the investment to be worth $200. It really is as simple as that. We can use the same rule to understand the impact of inflation on the value of money as this is also a compounding calculation. This enables to understand how long it would take for our buying power to haul. And 3.5% annual inflation, 70 divided by 3.5 equals 20, which means that our buying power will have in 20 years time. This is important if we have a substantial amount of money held in cash and inflation is increasing. This table illustrates the impact of interest rates on the time it takes to double your investment at 13 percent rates of interests or compounding rates of return on your investment will double in just 4.8 years. While this calculation is only approximate. For a useful rule of thumb. And to be able to do quick calculations, it is very useful and will help you to appreciate the impact that compounding can have on your investments. So that's compounding the Rule of 72. Tuck that away in your toolbox. It's a really helpful quick calculator. And when you're considering investment returns scenarios, then it's one you definitely want to apply to see the impact that rates of return and interest rates can have on your long-term investment strategy. 5. Why is Liquidity important?: Now we need to discuss why is liquidity important. Liquidity is an important principle in stock market investing that you need to understand. Liquidity refers to the ease with which an asset or security can be easily converted into cash critically, without affecting its market price. The most liquid asset of the mall is of course, cash itself. Other assets such as property ODD, and other collectibles are relatively illiquid. That means that if you want to sell them, it may take some time to find a willing buyer. Or if you are in a hurry, you may have to discount the price. We can talk about liquidity in the context of the stock market. A market with high liquidity is one where acids can be readily bought and sold at their market value. Providing there is not an imbalance of buyers and sellers. The bid and offer price will be close to each other. If an investor wants to sell or stock or an investment in a liquid market, she will be able to do this without having to significantly, significantly discount her price. Real estate markets are less liquid, as you will know, if you've ever tried to sell your house. It may take weeks or months of advertising to attract a buyer who's prepared to pay close to what you are offering the property fall. In other markets such as derivatives, bonds, options, and swaps, the liquidity will depend on the size of the market and the number of buyers and sellers at any particular point in time. We can also consider liquidity in the context of company accounting and in particular, balance sheet assets, it is useful to understand how easily a company can pay its liabilities from its assets. And the significant factor in this is the liquidity of the assets themselves. On the balance sheet, we typically find cash or cash equivalents, accounts receivable, short-term investments, inventory, plant and machinery, and property. These are listed in order of liquidity with cash, the most liquid and property, plant and machinery, the least liquid. We can use the current ratio to measure the ratio between current assets and current liabilities. A ratio greater than one indicates that the company can cover its current liabilities with its current assets. The quick ratio or acid-test, excludes inventories from current assets as these are less liquid than cash and cash equivalents. These liquidity ratios enable us to evaluate how solvent the company is. Should it encounter a significant business problem? When investing in the stock market, you should always keep liquidity at the front of your mind. This may include keeping a proportion of your investment portfolio in cash. This can be useful if Mach is suddenly turn and liquidity is affected. In particular, if the market is fall and stop, families become more attractive. You need to have cash to be able to take advantage of the correction. At such times, market liquidity may be low and cash will be critical to your ability to invest. Equally. You may decide to purchase a stock on your watch list and having cash available to make the investment without having to sell something else is important. It is also advisable to keep a cash reserve outside of your investment portfolio so that you always have sufficient cash to meet unexpected bills or an interruption to your income. Liquidity is therefore a critical stock market investing principle, which you must always keep in mind in all your financial planning and stock market investing strategies. So that is your introduction to liquidity. Definitely keep it in mind and always make sure that you have some cash reserve in whatever investing strategies you decide to adult. 6. What do we mean by Volatility?: Thanks principle we need to take a look at is volatility. So let's ask the question, what do we mean by volatility? Volatility is another important stock market investing principle, which you do need to understand. Volatility is a measure of the amount by which the price of a security fluctuates compared to movements in the market. It is frequently used as a measure of risk. The more volatile the stock price, the higher the company's risk. Technical traders also use it as part of their calculations when trying to assess future movements in prices. Volatility can also apply to the whole of the market or to collective investments such as mutual funds, investment trusts, and exchange traded funds. Volatility can be caused by political and economic factors, industry and sector factors, and company-specific factors and performance. In the capital asset pricing model, which is used to value companies. Volatility is measured by the company's beta. Beta, or the volatility of the stock in the capital asset pricing model measures the relative risk of the stock and its price to the whole market. So in the capital asset pricing model, volatility equals beta equals company's specific risk. The CAPM Capital Asset Pricing Model would argue that investors always seek to obtain the highest rate of return for the lowest levels of risk, and therefore use the Beta volatility as a mathematical way of measuring that risk. Investors, such as Warren Buffett do not accept that there is a connection between stock price volatility measured by the beta and the inherent risk in the business itself. Why do you need to understand volatility and Beta? You should not accept critically that this is a valid measure of company risk. We will discuss these issues later in the course in more detail when looking at price and company valuation in general and the capital asset pricing model in particular. For Benjamin Graham's Intelligent Investor, volatility is simply part of the normal conditions you encounter. As a long-term investor. We would encourage you as a long-term stock market investor to accept the volatility is just part of the landscape. There will be times when markets and stokes have high volatility and other times when volatility is low, we would encourage you to accept this as the normal state of the market and not react or change your strategy simply because the level of volatility has changed. So that's an explanation of volatility. You need to understand it. You will certainly hear a lot about it. And you will also hear a lot about betas and the capital asset pricing model. But don't worry, we are going to cover those topics off. They're important topics and they need to be dealt in the, in their own right and at the right time. But for the moment, all you need to focus on is to make sure that you understand what we mean by volatility. 7. Why is Diversification important?: Let's take a look now at diversification and ask, why is diversification important? Diversification is a risk management technique that involves mixing a wide range, a wide variety of investments in order to produce higher long-term returns. While at the same time, lowering the risk. Risk is reduced by spreading investments across a range of financial instruments and stokes. So that in the event of an adverse event, the blend of investments reacts differently. And the impact of the adverse event on returns is reduced. While unsystematic risk can be mitigated through diversification, systematic or market risk cannot. Unsystematic risk is the risk attributable to a specific company or industry. Systematic risk affects the market as a whole, not just one stock or sector. If you have a portfolio comprising only technology stocks and major adverse industry of fate will affect all the stocks in that industry. If you only hold Apple Inc. And they make a negative announcement, you're exposed to the risk of the decline in that share price. However, if you hold an E3 technology stocks in a portfolio of 20, then the adverse effect will only affect those three stokes. The diversification in your portfolio will have reduced the negative impact on your portfolio arising from the negative event. The critical issue is the extent of correlation between the stocks in the portfolio. If you have a range of Stokes, but they are highly correlated, you will not have successfully diversified holding hardware, software, and internet stokes would be an example of an uncorrelated portfolio. You can also apply diversification to asset classes as well as different types of stokes. So holding 25 percent of your portfolio and bonds and 75 percent in stokes would diversify your risk. Location is another issue, holding only US or UK Stokes exposes you to country risk. An index fund of European stokes would help to reduce that country or location specific risks. How many stocks should you hold? It's generally accepted that holding between 50 and 20 Stokes is sufficient to achieve a significant level of diversification. Providing the stokes a carefully chosen holding many more stocks than this achieves only limited further diversification and stalls to potentially erode the opportunity to outperform the market. One simple approach to diversification is to invest in index and mutual funds, which come with a ready-made basket of different investments. Some funds, however, have themes or are specific to come trees or locations. In which case, an investment in several unrelated funds could diversify this element of risk. While in theory, diversification is a positive concept and can help protect the investor, it can be complex and expensive to implement in practice. It can also reduce investment returns. And of course, you can never diversify away all the risk. So that's the concept of diversification. I hope you understand now that it is important to literally not have all your eggs in one basket, but to have a range of investments across maybe a different asset classes, different countries, different investment themes, so that any specific adverse event will not affect your entire investment portfolio. 8. The Time Value of Money: The next topic I want to discuss with you is the time value of money. This is one of the most important concepts in finance and in particular is relevant to stock market investing. In essence, a dollar today in your hand is worth more to you than a dollar tomorrow. Let's explore this in more detail. The main justification for the time value of money is that money can be earning you more money over time. This is also referred to as the net present value or NPV. If an investment offers you a cash return of $100 in one year, it is worth more than an identical investment, but which pays you $100 in two years. The $100 in one year has a higher present value than having to wait two years. The time value of money is central to all discounted cashflow valuations. The future cash flows are discounted to the present value using a discount factor or an expected rate of return. This works out in our favor when we're investing in the stock market. If we make an investment today, the earnings from that investment started to benefit us, and this continues over time. As we have seen, the power of compounding can make a significant impact on our returns. The time value of money is also impacted by inflation and purchasing power. Inflation erodes the value of money over time and therefore its purchasing power. A gift voucher issued in 2010 and spend today will buy you less today than in 2010. This means that when we are considering our investment returns, we have to factor in the impact of inflation. If inflation is higher than our returns, then your returns would be negative and you will be losing money in real terms. Calculating the net present value is not difficult. The formula is PV equals FV divided by one plus I to the power of n. So PV equals the present value, FV equals the future value. I is the interest rate or required rate of return, and n is the number of time periods. So what is the body of $100 received in three years time? If we're expecting a rate of return of 10 percent, well, present value equals future value, so that's 100 divided by 10% is one plus 0.1. So that's 1.1. Power of 3. 1.1 to the power of three is 1.331. So 100 divided by 1.331 is 75.131. This means if we could pay less than $75.75, $0.131 for this investment, it would be a good deal. We can also use this formula to look at the future value by rearranging the bay or variables, we switch PV and FV, and we changed the, the, the formula instead of being a division, it becomes a multiplication. So what's the future value of $100 today if it has a rate of return or interest rate of 10 percent. So the future value is $100 times 1.1 to the power of 3. So that's 100 times 1.331, which is $133.1. This is just an introduction to the time value of money and discounting. As we move through this course, we will discover the understanding the time value of money and being able to calculate present and future values will be critical to our understanding of stock market investing. So that's your introduction to the time value of money. And I'm sure it's easy to understand the concept that a dollar today is worth more than a dollar tomorrow. But what you need to grasp is the ability to calculate either the present value of the future value of a series of cashflows to then find out what sort of returns you are making. 9. Five Essential Stock Market Principles Summary: Let's review then the five essential stock market principles. In this section, we have established some important foundations for stock market investing by covering some fundamental principles. Let's revise these in summary. We now understand the power of compounding. Remember the grains of rice on the chessboard. Starting with one grain, the 64th square represented 210 billion tons. Warren Buffett, as you can see from the diagram, has only become seriously rich in the last 20 years. And the compound interest table that we looked at enables you to calculate the power of compounding for different rates of return. We discussed the rule of 72 to show you how to quickly calculate the time it takes for an investment to double based on a given rate of return or interest rate. The table shows the calculations. In summary, the importance of liquidity was highlighted in two key respects. The ability to buy and sell an asset without compromising his price, and the importance of retaining some cash to take advantage of investment opportunities when they arise. Next, we looked at volatility. So often this is used as a proxy for measuring risk. But we challenge the thinking behind the capital asset pricing model, which uses beta volatility as a part of its formula to represent company-specific risk. We also learned that price volatility is to be expected in stock markets and can have a wide range of causes. In summary, volatility is something that you have to live with and it should not dictate your investment strategy. Managing investment risk is always important. And the key strategy is diversification. In simple terms, not keeping all your eggs in one basket. We discovered that 15 to 20 Stokes is sufficient to diversify systematic risk, but the stokes must not correlate with one another as a basket, all technology stocks would, for example. Finally, we discussed the time value of money. A dollar in the hand today is worth more than a dollar tomorrow. Importantly, this showed us that you can calculate both the present value and the future value Given a known rate of return, the interests intervals and the number of periods. This is the core of discounting, which we will discuss further in future lectures. The has been a lot to cover in these five principles. Now we can move forward and deepen our understanding of stock market investing. So I hope you found these principles helpful. These are the sorts of key issues and fundamental cornerstones of stomach investing that you do need to understand before we can really get further in and deeper into the topic. 10. Stock Market Investing Part 2 Five Essential Stock Market Principles Summary: This is just the concluding lecture to part two of my stock market investing goals, five essential stock market principles. So first of all, congratulations on completing part 2 of the stock market investing course. I really hope you found it informative, engaging, and more than ever enjoyable. Your next step is now to complete the course assignment, which is a short five question multiple choice test. To see if you've understood the main lessons of the course. The answers you'll be very pleased to know are downloadable in the attached Word document. In part 3 of my stock market investing course, we're going to take a look at stock market investing wisdom for new investors. Taking a look at some of the key insights based on over 30 years of stock market experience, which may not be appreciated by new investors. Make sure that you click on the Follow button so that you get notified when my classes go live. And thank you very much for taking this course and I look forward to seeing you very soon in stock market investing part 3. So that concludes our stock market investing part. To really hope you've enjoyed the course, I'm having a lot of fun putting all this together for you, and I look forward to seeing you very soon in part 3.