Should You Pick Stocks?

The next two layers of the ‘asset allocation model’ concerns buying and holding individual stocks as part of your strategy to growth your wealth. The risks involved are much higher and concentrated at these levels, so it would be best to only start allocating money to this level, once you have appropriately mastered and allocated your wealth in the levels below.

As I mentioned in the post before this, there are safer ways to get into stocks and you should seriously consider those ways if you are just getting started. Only once you are comfortable with your financial position and ready to take on more risks, read on.

I’ve now given you all the warnings. Proceed with caution.

Employee Stocks

If you work for a publicly traded company there is a chance that they will offer you employee stocks as part of the company benefits. The idea is to get you invested in the company’s financial success – when the company does well, the shares go up in value and therefore the benefits will be worth more to you.

Typically the shares would be offered to employees at a discount to the market price. The discount is a price buffer that protects you in case the share price drops as the shares get vested to you.

I mentioned in the 2nd series of the posts that employee stocks can be a way to accelerate your savings as you work towards one of your first major financial goals. This point will still remain relevant as you build up your asset allocation portfolio.

The key point however is to make sure that over time, you re-allocate your wealth in employee stocks to other investments as it grows in value. This ensures that your wealth is protected during the times when your company shares suffer.

What I typically do is to make sure that the total value of vested employee shares do not exceed 15% of my investments in shares (inclusive of shares in funds). The choice of 15% is kind of arbitrary for me. You can decide your own percentage based on what’s comfortable to you.

During good times, your company shares will rise in value. It may even rise faster than the general market. As the price goes up, its total value will exceed the percentage threshold that you set. Say that it’s now 20%. So what I do is that I sell off enough shares to bring it down to 15% or lower (or whatever percentage you set). Recycle the money by allocating it to other investments. Or take some of it out for a well deserved family vacation. The choice is up to you.

During bad times, it’s likely that the value of employee shares will remain below the % target. Just keep the shares and enjoy the dividends if any.

This common sense practice is also done by CEOs (here, as an example). Up till the peak of September 2018, management were busy selling their shares. So they are doing what’s right to manage their personal wealth. But it certainly looks bad from the outside.

Typical company founders who are also CEOs will seldom sell their stakes since that will erode their control over their companies. This is an extreme concentration of wealth, something that I will talk about in a future post of this series. To be fair, these CEOs are driven by the success of their company – their personal wealth comes second. As the risk vs reward relation goes, if the company makes it, the founders get immensely rich from the capital gains of their shares. Does it surprise you that 9 out of the top 10 wealthiest people in 2018, make their wealth in business? The odd one out is Warren Buffet who made his wealth through investments.

Individual Stocks

Companies have 2 ways to raise cash to run or expand their businesses. One is to borrow. The other is to raise equity through shares. Raising equity means dividing or splitting the ownership of the business into tiny units and selling the units to whoever that wants to own part of the business. The units of equity are known as shares or stocks.

There is no limit to how many shares a company can create. For example, Maybank has about 11 billion shares. On the other hand, Allianz Malaysia has 177 million shares. Maybank’s share price is currently around RM9.45 while Allianz is RM13.36. Although Maybank’s share is cheaper, instinctively we know that as a company, it should be valued a lot more than Allianz Malaysia – it has a bigger ASEAN presence, it has more customers, it has more assets, more financial services etc. Hence if you multiply the share price with the total number of (outstanding) shares, you get the market capitalisation of the company, a reflection of how much the public THINKS the companies are valued. For Maybank, that works out to be RM104 billion while for Allianz Malaysia, it is RM2.4 billion.

So the value of a listed company is a matter of public opinion coming to consensus in the form of its share price. If a shareholder thinks that the value of the company has gone down, s/he may choose to sell her/his shares to someone else who thinks that the value should be higher. The price at which the shares are exchanged will determine the new value of the company. This method of stock investing is called value investing and it requires some knowledge to be able to estimate the future worth of the company. You can watch some videos from Aswath Damodaran (Finance Professor at NYU) to learn how company valuations can be performed.

Of course, there are many people who buy and sell shares without actually thinking about the value of a company. They look at price and volume charts and distill some form of pattern or trend, a method called technical analysis. Based on what they ‘see’, they make a guess when to buy or sell shares. One popular concept is momentum investing where they buy into shares that have a strong upward trend and sell when the trend reverses.

Now let’s play a Bandersnatch-style game that simulates a stock trading scenario to see what can happen in real life. You begin with an imaginary RM10,000 worth of cash available in your stock brokerage account. Follow the instructions carefully starting from STEP 1:

1. You perform your stock analysis and come up with 2 possible stocks where you can put your money: Maybank which is currently at RM9.80 and Allianz which is at RM13.50. Your brokerage firm publishes an analyst report that values Maybank at RM12.00 (a Buy recommendation, 22% upside) and Allianz at RM 18.00 (also a Buy recommendation, 33% upside). If you think you have sufficient info to buy one of these stocks go to STEP 2. Otherwise, go to STEP 3.
2. With the analyst report in hand, you believe that you have enough info to make a decision. If you choose Maybank, go to STEP 4. If you choose Allianz, go to STEP 5.
3. You choose to consult your super trusty price chart. Below are the 1 year charts for Maybank and Allianz together with their 50 and 200 moving average days trend lines. If you choose to invest in Maybank go to STEP 6. If you choose Allianz, go to STEP 7.
4. You have decided to trust the 22% upside prediction of the analyst report and put down RM5,000 into Maybank. Although it’s lower than the 33% upside for Allianz you have a stronger believe in the strength and brand of Maybank over Allianz. You have RM5,000 remaining in cash. Go to STEP 8.
5. You have decided to trust the 33% upside prediction of the analyst report and put down RM5,000 into Allianz. It’s more than the 22% for Maybank so you have more ‘margin of safety’. You have RM5,000 remaining in cash. Go to STEP 9.
6. Your trusty chart reveals that the upward trend is still strong with Maybank and the current price is close to the 200 day average. You put down RM5,000 into Maybank. You have RM5,000 remaining in cash. Go to STEP 10.
7. You compared the 2 charts and although both long term trends are upward, you notice that the 50 day moving average line has dipped below the 200 day moving average line for Maybank. With that, you decide that Allianz is a better bet and put your RM5,000 into Allianz shares. You have RM5,000 remaining in cash. Go to STEP 11.
8. There’s a euphoria of excitement post the May 9 general election in Malaysia. However there is a lot of uncertainty and many politically linked stocks are crashing. Maybank is unfortunately not immune and within a month, the price has dropped to RM9.00. You are sitting on a paper loss of RM408 (8%). Do you still believe in the analyst report with RM12.00 price target? If yes and you choose to double down your investment go to STEP 12. If you believe the report but choose not to do anything go to STEP 13. If you want to cut your losses and sell everything, go to STEP 14.
9. The stock price of Allianz held more or less steady up till the release of its latest quarterly financial results that showed a slight decline in profits relative to the same quarter last year. In 5 weeks’ time the price has dropped to RM11.60. You are now sitting on a paper loss of RM704 (14%). Do you still believe in the analyst report with RM18.00 price target? If yes and you choose to double down your investment go to STEP 15. If you believe the report but choose not to do anything go to STEP 16. If you want to cut your losses and sell everything, go to STEP 17.
   
10. There’s a euphoria of excitement post the May 9 general election in Malaysia. However there is a lot of uncertainty and many politically linked stocks are crashing. Maybank is unfortunately not immune and within a month, the price has dropped to RM9.00. You are sitting on a paper loss of RM408 (8%). Your chart is showing a reversal in trend. Do you trust your chart and sell everything? If yes, go to STEP 14. If you ignore your chart and choose to double down on your investment, go to STEP 12. If you choose to do nothing and hold onto your shares, go to STEP 13.
11. The stock price of Allianz held more or less steady up till the release of its latest quarterly financial results that showed a slight decline in profits relative to the same quarter last year. In 5 weeks’ time the price has dropped to RM11.60. You are now sitting on a paper loss of RM704 (14%). Your chart is showing a reversal in trend. Do you trust your chart and sell everything? If yes, go to STEP 17. If you ignore your chart and choose to double down on your investment, go to STEP 15. If you choose to do nothing and hold onto your shares, go to STEP 16.
12. You made the choice to double down on your investment. You put down the remaining RM5,000 that you have purchasing additional shares at RM9.00. Eventually in about 6 months, the share price has increased back up to RM9.50. Your decision to double down on your earlier investment reduced your average purchase price to RM9.38. You made a final paper profit of RM124 (1.25% of RM10k). Phew!
13. You made the choice to not do anything with your investment. Eventually in about 6 months, the share price has increased back up to RM9.50. You made a final paper loss of RM153 (-1.5% of RM10k). A narrow loss.
14. You made the choice to cut your losses and sell all your shares at RM9.00. Eventually in about 6 months, the share price has increased back up to RM9.50. You made a final real loss of RM408 (-4% of RM10k). A loss!
15. You made the choice to double down on your investment. You put down the remaining RM5,000 that you have purchasing additional shares at RM11.60. Eventually in about 6 months, the share price has increased back up to RM13.00. Your decision to double down on your earlier investment reduced your average purchase price to RM12.48. You made a final paper profit of RM418 (4% of RM10k). Yay!
16. You made the choice to not do anything with your investment. Eventually in about 6 months, the share price has increased back up to RM13.00. You made a final paper loss of RM185 (-1.9% of RM10k). A narrow loss.
17. You made the choice to cut your losses and sell all your shares at RM11.60. Eventually in about 6 months, the share price has increased back up to RM13.00. You made a final real loss of RM704 (-7% of RM10k). A loss!

If you didn’t skip the game, congratulations on finishing it! The example above is based on the actual stock prices for Maybank and Allianz in 2018. Their initial prices were from the start of 2018. The price targets were close to actual price targets issued by brokerage firms. The price fluctuations were real and the final prices were the prices at the end of 2018.

If you have finished the game on step 12 or 15, then you would have just performed ‘cost averaging’, purchasing more shares as its price goes down in order to reduce your average buying price of the shares. You have a tolerance for high risks, you believe in the long term value of the company that you chose and you are investing for the long term. Even if you had chosen to trust charts at the start, you end the game as a value investor instead.

If you have finished the game on step 13 or 16, you have a medium tolerance for risks. When the share price dropped unexpectedly, you froze on what to do next and decided to preserve your cash. If you chose to trust the analyst report at the start, you may have doubted the accuracy of the analyst report later. Conversely if you chose chart reading at the start, you eventually ignored it although it was clear that the trend was changing. You ended the game with an average result.

If you finished the game on step 14 or 17, you have a low tolerance for risks. If you chose chart reading at the start, you continued to believe it and took action when you realise that the trend had turned. If you started by trusting the analyst report at the start, in the end you abandoned it. You ended the game with a poor result.

From the game you would have realised that stock picking isn’t easy. Even analyst reports and price targets can be misleading since no one is a fortune teller that can tell the future. You may think that you can balance out your fortunes by buying several stocks. However, if you have limited funds you cannot truly diversify away your risks. You would concentrate your funds in a few selected stocks at a time. If you keep your conviction in those stocks you would hold them and average down your purchase price when their prices drop. Sometimes it works. But sometimes you really end up with a dud and realise it too late.