Stock Market Education For Beginners - Learning From Your Mistakes

Have you lost money in the stock market? Okay, that might seem like a stupid question with most major share indices down by almost 50% from their highs. But just humor me. Have you made some poor stock market investment decisions which have resulted in a permanent loss of capital (beyond the paper losses you're probably sitting on just now)? If you're like most average investors, including myself, you probably have.

It's never fun losing money, but if you look at it in a positive light, it's a great opportunity to learn a thing or two about investing and maybe even something about yourself. In fact you could even look at the funds you've lost as an investment in your stock market education.

In my recent post Analyzing Your Stock Market Investment Performance, I discussed the need to measure your investment performance and to benchmark that performance against financial returns generally. I don't want to labor the point, but I think it's a very important step in the investment process and one which some investors seem to ignore (the professionals as well as stock market beginners.

The next logical step in this process is to drill down and take a close look at the results of some of your individual investments. We have a tendency to congratulate ourselves when an investment goes well and we make money out of it. But many of us also have a habit of downplaying our investment losses, treating them as an aberration. "Let's just sweep that one under the carpet... move on - there's nothing to see here!"

But to become better investors we each need to be able to stand back and objectively analyze the losses we've made in order to work out what went wrong. In order to do this you really need to get inside the investment.

Objectively analyze the position the company was in when you bought into it. Now compare that to how it looked when you sold. Did the state of affairs deteriorate in the period over which you held the stock? If so, was that foreseeable? Did you pay a premium for what looked like a rapidly growing business, only to see the price plummet when that growth didn't eventuate or wasn't is high as the market wanted?

Revisit your thinking. Why did you buy the stock in the first place? Review any notes you may have taken at the time. See if you can recall the reasoning which led to the original acquisition. It's important to be honest with yourself and not just rationalize your actions after the event.

The goal of this exercise is not to shame and humiliate yourself, but rather to identify any shortcomings in your investment process or in your stock market strategy as a whole. Only then can you take steps to address these shortcomings, refine the way you make investment decisions and reap the benefits of out-performance of future gains.

The end result might be a fundamental shift in your investment philosophy. Or it may just be a minor adjustment to the process you follow - an extra filter, or another point to add to your analysis checklist- learning to get back to stock market basics. I'm a big believer in being patient - invest less frequently and only when you're convinced of the value being offered.

Investment Lessons I've Learned...

While there are way too many lessons for me to list in this post, here are a couple of the more expensive lessons I've learned in the past.

First Mistake - Too Much Debt!

As a stock market beginner, one of my first forays into the market resulted in me buying stock in a company which looked extremely cheap based on fundamentals. Things like price to earnings and dividend yield. In my efforts to learn stock market investing concepts I'd read that value investors like Benjamin Graham and Warren Buffett had made money by investing in extremely cheap bargain stocks - and being a contrarian, I figured this business fit the bill perfectly. What I didn't take into account was the amount of debt the company carried and that the cost to the company of servicing that debt meant that a decent breeze blowing through the economy might be enough to bring the whole thing down. Investors had marked down the price accordingly but I was too naive to recognize the very real risk of insolvency. I know - every half-decent stock market guide & tutorial you read will warn you about this but I had to find out for myself.

While the company did survive, it had to re-capitalize and in the process destroyed a significant amount of shareholder value. This investment resulted in a permanent loss of capital on my part. While I was diversified enough for it not be cause undue hardship, it still stung to lose money. That was a big leap forward for me in understanding the stock market.

Anyway, since then I've been much more careful when investing in companies whose debt may turn out to be a problem. Using tools like the quick ratio and debt to equity ratio I've been able to navigate my way through the latest financial crises relatively unscathed. I should explain that last statement. While I, like most other investors, am sitting on paper losses for a few of my investments, none of the companies I own have encountered any fundamental problems due to the credit crunch. Rather their prices have suffered along with the general market. But each of the businesses is strong and still growing in value and I believe in more stable market will sell for prices significantly in excess of what I've paid for them.

Second Mistake - Believing What Management Say.

This is another lesson I learned from the situation I described above. Management constantly downplayed the risks associated with the financial position of the company. They continually attributed low probabilities to certain financial events which may or may not have occurred. Without going into specifics, lets just say I think I had the wool pulled over my eyes.

When I looked back on the matter (hindsight's a wonderful thing) a couple of things became clear. The financial reports were at odds with the soothing noises which emanated from the upper echelons of management. And I noticed the guys running the show had no skin in the game - they had none of their own personal wealth invested in the company. No wonder they weren't worried!

As usual, I've gone on much longer than I intended, but the upshot of all of this is that I now have a couple of extra boxes to tick before I'm willing to part with my hard-earned cash.

So take some time to learn from your investment mistakes. After all, you've already parted with the funds so you may as well get value for your dollar and advance your stock market education.

Quick Ratio Formula

A discussion of the formula for quick ratio calculation for the stock market beginner.

Following on from my article on debt to equity analysis, today I'd like to talk about the quick ratio, also known as the acid test ratio or just acid ratio. This measure takes into account the more immediate liquidity or cash flow requirements of a business. Investors should use this tool when conducting their financial analysis of potential stock market investments to confirm a company's ability to meet its short term obligations.

The most common representation of the formula is as follows:

QR = (Current Assets - Inventory) / Current Liabilities

There are other variations (which I'll discuss shortly) but this simple calulation does the trick in most cases. A quick explanation of the above formula is probably in order.

Since we're trying to determine an organization's ability to meet its short term funding requirements, we take cash and cash equivalents and divide them by current liabilities. The reason we subtract inventory is that it may not be easily converted into cash or if it is, it may be at less than face value (think of 50% off sales).

At this point you may be thinking "But what about other current assets which can't easily be converted to cash?". If you weren't thinking that, or if you're now wondering what current assets are, stay with me - I'll try and make this as painless as possible.

This school of thought is where one of the more common variations of the quick ratio comes from.

QR = (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities

The difference in this representation of the formula is that we are only using truly 'liquid' assets in the numerator. By only using cash, cash equivalents (short term investments and the like) and accounts receivable (short term money owed to the company) we'll be leaving behind the other potentially non-liquid current assets (things like prepayments or income tax benefits which can't really be converted to cash).

So What Is A Good Quick Ratio?

Common wisdom has it that anything over 1 is acceptable. But as with many of these financial ratios and with financial statement analysis in general, they should be compared among companies within the same industry and also for the same company over time (is the position improving or deteriorating). This should be the approach taken with all stock market formulas.

Is A High Quick Ratio Good?

This is very subjective. In general, an excessive quick ratio may mean the business is not using its assets efficiently (I'm sure shareholders would prefer to look after the cash themselves rather than having it sit on some company's balance sheet). But there maybe legitimate reasons to build up a buffer of cash. It might be in anticipation of lean times ahead for example.

The quick ratio is especially important now. As I write this, world stock markets are in turmoil after the collapse of Lehman Brothers. With consumer spending down and debt funding in short supply, businesses need to be able to survive on internal funding now more than ever.

One criticism of the quick ratio is that it doesn't take into account the timing of cash flows. For example, analysis of current liabilities may show a large proportion of short term commitments fall due within 30 days but accounts receivable may be 60 or even 90 days. This mismatch or cash flow timing could cause problems.

An Example:

What follows is the calculation of the quick ratio for Johnson & Johnson (JNJ) based on the 2008 figures from Yahoo Finance.

JNJ QR = (35,817,000 - 5,700,000) / 21,780,000
= 1.4

or

JNJ QR = (12,646,000 + 412,000 + 13,151,000) / 21,780,000
= 1.2

As you can see, the second version of the formula gives the more conservative result.

I know I've covered some fairly technical stuff today, but if you're serious about making money in the stock market (or perhaps more accurately - not losing money) then you'll need to do your homework. After all, even beginners' stock market investing requires thorough research and the quick ratio provides an important indicator as to the financial health of any business.