If you have heard fund managers talk of the way they invest, you know a lot employ a top down approach. First, they decide what quantity of their portfolio to allocate to stocks and how much to allot to bonds. At about that point, they may also decide on the relative mixture of domestic and foreign securities. Next, they decide upon the industries to invest in. It's not till all these choices have been made that they actually get down to researching any actual stocks. If you think logically about this approach for but a moment, you'll recognize how actually foolish it is.
A stock's takings yield is the inverse of its P/E proportion. Hence a stock with a P/E proportion of 25 has a revenues yield of 4%, while a stock with a P/E ratio of 8 has a revenues yield of 12.5%. In this fashion, a low P/E stock is analogous to a high yield bond.
Now, if these low P/E stocks had really unbalanced takings or carried lots of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. But many low P/E stocks actually have more steady revenues than their high multiple family. Some do employ a large amount of debt. Still, within recent memory, one could find a stock with a takings yield of 8 12%, a dividend yield of 3- 5%, and literally no debt, regardless of some of the lowest bond yields in half a century. This situation could only come about if backers shopped for their bonds without also considering stocks. This makes about as much sense as purchasing a van without also considering an automobile or truck.
All investments are at last money to cash operations. As such, they should be judged by a single measure: the discounted value of their future money flows. Because of this, a top down approach to investing is nonsensical. Starting your search by first deciding on the type of security or the industry is a director deciding on a left handed or right handed pitcher before evaluating every individual player. In both cases, the choice is not simply hasty; it's fake. Even if pitching left handed is inherently better, the director is not comparing apples and oranges; he's comparing pitchers. Whatever inherent advantage or downside exists in a pitcher's handedness can be reduced to a ultimate value (e.g, run price). For this reason, a pitcher's handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the kind of security. It is neither more obligatory nor more logical for a stockholder to prefer all bonds over all stocks (or all shops over all banks) than it is for a director to prefer all lefties over all righties. You needn't determine whether stocks or bonds are tasty; you need just determine whether a selected stock or bond is sexy. Similarly, you need not decide whether the market is undervalued or unrealistically priced; you need simply determine that a particular stock is undervalued. If you're convinced it is, buy it the market be damned!
Clearly, the most provident approach to investing is to guage each individual security in relation to all others, and only to think about the form of security insofar as it has effects on each individual evaluation. A top down approach to investing is a unnecessary hindrance. Some extremely smart investors have imposed it on themselves and overcome it; however there is no need for you to do the same.
A stock's takings yield is the inverse of its P/E proportion. Hence a stock with a P/E proportion of 25 has a revenues yield of 4%, while a stock with a P/E ratio of 8 has a revenues yield of 12.5%. In this fashion, a low P/E stock is analogous to a high yield bond.
Now, if these low P/E stocks had really unbalanced takings or carried lots of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. But many low P/E stocks actually have more steady revenues than their high multiple family. Some do employ a large amount of debt. Still, within recent memory, one could find a stock with a takings yield of 8 12%, a dividend yield of 3- 5%, and literally no debt, regardless of some of the lowest bond yields in half a century. This situation could only come about if backers shopped for their bonds without also considering stocks. This makes about as much sense as purchasing a van without also considering an automobile or truck.
All investments are at last money to cash operations. As such, they should be judged by a single measure: the discounted value of their future money flows. Because of this, a top down approach to investing is nonsensical. Starting your search by first deciding on the type of security or the industry is a director deciding on a left handed or right handed pitcher before evaluating every individual player. In both cases, the choice is not simply hasty; it's fake. Even if pitching left handed is inherently better, the director is not comparing apples and oranges; he's comparing pitchers. Whatever inherent advantage or downside exists in a pitcher's handedness can be reduced to a ultimate value (e.g, run price). For this reason, a pitcher's handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the kind of security. It is neither more obligatory nor more logical for a stockholder to prefer all bonds over all stocks (or all shops over all banks) than it is for a director to prefer all lefties over all righties. You needn't determine whether stocks or bonds are tasty; you need just determine whether a selected stock or bond is sexy. Similarly, you need not decide whether the market is undervalued or unrealistically priced; you need simply determine that a particular stock is undervalued. If you're convinced it is, buy it the market be damned!
Clearly, the most provident approach to investing is to guage each individual security in relation to all others, and only to think about the form of security insofar as it has effects on each individual evaluation. A top down approach to investing is a unnecessary hindrance. Some extremely smart investors have imposed it on themselves and overcome it; however there is no need for you to do the same.
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