Are you looking to grow your savings for the future? One way to do that is by investing in the stock market. But do you trust yourself enough to make the right investment decisions? Most of us prefer to leave it to the experts, but did you know they often charge high fees and don't always get it right? Here's the thing, the best way to maximize your stock market profits is by managing your own investments. But how do you do that? Well, in “The little book that beats the market”, Joel Greenblatt shows us the key factors to look out for when choosing the right stocks. He calls it the magic formula and If you follow his advice, you'll be able to beat the market average by a good margin. In this summary, I’ll share with you three key lessons that I learned from his book.
Key Lesson #1: Don’t trust the so-called financial experts with your money
Investing in the stock market is the best way to increase our money. But most of us only have a basic understanding of how the stock market works, so we turn to financial experts for help. But the sad reality is that most of these so-called "experts" are not worth their fees. Take stockbrokers for example. Many of us use their services, but the truth is, they are not the best people to trust with our money. Stockbrokers get paid by selling you investment products, regardless of their profitability. So, they have no incentive to sell you the best products available, they just need to sell you anything they can. Another option is a mutual fund, where investments from many people are pooled together. However, these usually come with a high management fee, so even though they often yield decent returns, by the time you subtract the fees, you're often left with below-average returns. But there is one type of financial investor who can manage your investments well – an index fund such as S&P 500. These funds aim to match the market's best performing companies, as opposed to trying to beat them. Even though this may seem a bad option but index funds often provide you with good profits due to their lower fees and the market's average performance. So if you don't mind having someone else manage your money, go for an index fund. But if you want to maximize your profits, there's no substitute for learning to do it yourself. Let’s find out how.
Key Lesson #2: Mr. Market is like an emotionally unstable person
Have you ever noticed that the stock values of companies can change rapidly in just a short period of time, even if there's no clear reason for it? It's like the stock prices are on a rollercoaster ride. Take a look at the stock prices of companies like Google or Amazon over the past 5 years. You might think the line would be a smooth upward slope, but it's actually more like a jagged line with ups and downs. Even successful companies experience these fluctuations in their stock prices. So why do these changes happen? It's because the stock market doesn't always reflect the true value of a company. Sometimes a company's stock price is undervalued and sometimes it's overvalued. It's like the stock market is an emotionally unstable person. Investment legend Benjamin Graham describes the market as a crazy person called Mr. Market. Mr. Market is like a crazy salesman who wants to sell you shares in his company. Some days he's overly optimistic and wants to sell his shares at a high price, but on other days he's feeling down and offering his shares at a lower price. This is where you can take advantage of Mr. Market's mood swings. Buy the shares when he's offering them at a lower price and then sell them back at a higher price when he's feeling better. It turns out there is a magic formula for doing this effectively.
Key Lesson #3: The magic formula combines earnings yield and return on capital
Do you want to make the most of your investment portfolio? Well, the secret is in the magic formula. There are two ingredients that make up the magic formula: the earnings yield and the return on capital. Earnings yield shows how much a company earns compared to its share price. The higher, the better. But just having a high earnings yield isn't enough. You also want to make sure the company is actually profitable, which is where the return on capital (ROC) comes in. So, if you buy shares of companies that have a high ROC at low prices, you're systematically buying into companies that are undervalued by Mr. Market. That’s the magic formula. Here's how it works. First, take a list of the biggest companies and rank them based on return on capital. The company with the highest ROC gets the top spot. Next, rank those companies based on earnings yield and the company with the highest earnings yield is given the top spot again. Finally, combine both rankings. So, a company that ranked number one in ROC but 181 in earnings yield will have a total score of 182. Then the magic formula will choose companies with the lowest combined ranking. But what does that mean for you? From 1988 to 2004, a portfolio of around 30 stocks suggested by the magic formula returned an average of 30 percent per year, compared to the market average of just 12 percent. That's why the magic formula is worth considering.
So, in summary, even though the stock market is the best place to invest money, but relying on financial experts is not the best way to make the most of the stock market. Mr. Market is emotionally unstable and stock prices fluctuate drastically in a short time. You can take advantage of this by relying on the magic formula and looking at the earnings yield and return on capital when making investment decisions.