Harvard Business School Confidential
Page 3
So the key is to find a bargain by identifying either a willing seller or a seller who has not been managing the property very well. By finding bargains and paying below market price, you can be more certain about locking in profit. There are many reasons why a property owner becomes a willing seller: relocation to another city, needing money for another investment or expense, time constraints, debt (including foreclosures by banks), divorce, sickness, or a hundred other factors. A property owner may not be managing the property well due to lack of time, interest, cash, or expertise.
Leverage, multiple streams of cash flow, and availability of bargains are three of the key advantages of real estate investing. There are two strategies in real estate investing: buy and sell quickly (flip) and long-term hold. The former is more risky. Most of the cash flow from flipping will be from value appreciation. Hence flipping requires more sophistication because you need to find bargains and know how to upgrade the property to increase the market value. Just buying at market price and hoping to sell at a much higher value quickly is a risky, speculative strategy. Long-term hold is relatively less risky as you can get multiple streams of cash flow.
POSSIBLE SOURCES OF INVESTMENT INCOME (II): PUBLIC STOCKS
Three key questions will guide you to investing in stocks: which stock, when to invest, and when to get out.
Which Stock to Invest In?
HBS offers multiple courses on finance. We spent months learning advanced concepts and techniques for valuing companies (and hence their stocks). But during the very last class of the course, one of my classmates, a very experienced banker, made a comment:
All these techniques are useful tools. But if you plan to use them to pick individual stocks, you should know this data I have read: 75 percent of all the smartest money managers in the world, working 20-hour days, with huge research staffs and the most advanced computers, have not been able to consistently beat the market averages. Of the remaining 25 percent, most were just able to keep pace with the market average. Only a handful of the rest (including Warren Buffett) have beaten the market consistently. But even for these few, many have beaten the market on average over a long-term, not if you look at short-term year by year.
I was shocked to hear this. I later found out from him that he had picked up the information from the book Multiple Streams of Income.8 The book provided further research evidence that in the years from 1990 to 2000 in the United States, out of over 6,000 professionally managed mutual funds, only 20 were able to outperform the market average after expenses and fees.9 Look at all the stock market commentators and so-called gurus around you—if they are so smart in picking stocks, they should be millionaires by now. Why are they still hosting radio shows and writing newspaper columns or research reports?
So what should you do? You can do one of two things. As mentioned earlier, there is a handful of Warren Buffetts around. You can invest in the funds they manage, but this could be tricky. First, past performance is not a guarantee of future performance. Past performance is not even a guarantee of future performance these days, as the people who invested with Bernie Madoff have learned at their cost. Second, Warren Buffett and a number of the other stars like him are quite old. So there is always the risk that their funds may significantly deteriorate after they retire. Third, some of these funds are not so easily accessible. Warren Buffett’s fund, Berkshire Hathaway, is traded only in the United States and at a high per-share price.
The second option is to invest in market average (stock market indexes such as the S&P 500 index fund or Tracker fund in Hong Kong). Most markets include investment funds that will track an index. They aim at providing the same return as the index by buying and holding all the stocks that make up the index. While it would be very difficult, if not impossible, to beat the market average by trying to pick individual stocks, you can still make a handsome profit if your investment performs at market average. Over the long-term (more than 10 years), the United States stock market index S&P 500 averages an annual return of 10 percent over 15 percent. Not a bad rate if you remember the principle of compounding covered earlier in this book.
This is why many HBS graduates invest in stock index funds. Of course, given the great ego many HBS graduates have, many still invest in investment funds and individual stocks. They either believe they can pick the 20 winners out of the 6,000-plus funds or believe they have enough information to pick individual stocks. But the risk involved in picking the right ones and the higher certainty of the index funds make stock indexes a better investment for most people. Also, index funds charge much lower management fees than other types of investment funds since index funds do not require research and have lower churn rates (the buying and selling of securities by fund managers, which incur commission costs and possibly taxes in some countries).
When to Sell
It may seem illogical, but it’s useful to tackle this question first, before going back to “when to buy.” Many people try to time the market. There is nothing wrong with a “buy low, sell high” strategy, except for the extreme difficulty of consistently timing the short-term highs and lows accurately. For example, in the 10 years 1980 to 1989, the S&P 500 index gained over 17 percent per year, with frequent short-term ups and downs. During this period, there were about 2,528 trading days. Almost 30 percent of the entire profit for the decade was generated in just 10 days. If you had tried to “buy low and sell high” but happened to miss those 10 days out of the 2,528, you would have lost almost 30 percent of your gain for the entire decade!10
It is difficult if not impossible to forecast the day-to-day or year-to-year ups and downs because stock prices are driven not only by business fundamentals but also by investors’ sentiment. Ben Graham, widely known as the Father of Financial Analysis and teacher to Warren Buffett, emphasized this element of emotion by comparing the stock market with an allegorical character he created called “Mr. Market.” Buffett shared this story with his investors in the 1987 annual report of his investment company Berkshire Hathaway. The story goes like this: imagine that you and Mr. Market are partners in a private business. Every day Mr. Market offers a price at which he is willing to either buy your shares in the business or sell you his. Although the business that you own jointly is a stable, predictable business, Mr. Market’s offers are rather unstable and often unpredictable. Some days, Mr. Market will offer a very high price because he is optimistic and cheerful. This could be because interest rates are down or another company announces good results or a war has ended and he can only see bright days ahead. On other days, Mr. Market can be very pessimistic and offers a very low price.
So what should you do? Should you be optimistic when Mr. Market is optimistic and be pessimistic when Mr. Market feels down? Graham believed that Mr. Market is very much like the real-life stock market, when short-term market prices are often driven by emotions that are irrational and ephemeral.
This is why Warren Buffett, one of the most famous investors in our time, has made his position on forecasting very clear in his books and speeches: Don’t waste your time. Whether it is the economy, the interest rates, the market, or individual stock prices, Buffett believes that forecasting these parameters is futile. But Buffett does not say the future is unpredictable. Two things about the future are certain:
The market will eventually reward great companies by increasing their stock price. But no one knows exactly when this will happen.
In the short-term, stock prices will always be volatile because of emotional factors, and because there will always be many speculators trying to predict short-term ups and downs.
So what does Warren Buffett do? He invests in great companies and holds them for the long-term. He does not care about any short-term price fluctuation. He will patiently wait as he is certain that the great companies he selects will eventually be rewarded. In fact, Buffett sees temporary price decline as an opportunity to buy more shares in the great companies in his portfolio.
The same approach applies to inves
ting in stock market indexes. Figure 1.2 shows the long-term trend of the S&P 500 of the United States.
History suggests stock market indexes increase over the long run. This is because indexes are made up of a basket of companies, and over the long-term, the good ones will get rewarded and the poor ones get eliminated from the indexes.
But indexes are going to fluctuate in the short-term, just like individual stocks. In the 50 years between 1950 and 1999, there were 11 years when the S&P 500 recorded a decline. That is roughly one losing year every five years. So if you buy in any one year during this period, and
Sell after one year, then your odds of winning will be roughly 80 percent (four out of five). Not bad, but still relatively high risk.
Sell after five years, then your odds increase to 85 percent.
Sell after 10 years, then your odds become 95 percent.
Sell after 25 years, then your odds of winning are almost 100 percent!11
Figure 1.2 U.S. Stock Market (S&P 500), 1950–2007
Source: Daily closings (S&P 500).
So the answer to “when to sell” is somewhere between 10 and 25 years. In fact, I have heard Buffett quoted as saying, “My favorite holding period is . . . forever.”
When to Buy?
If the key is to hold for a long period of time, then the time to buy is as soon as possible. The sooner you buy, the longer you have your money (employees) at work, and the more money you have to compound. If you fully subscribe to the theory that you cannot time the market, then the time to buy will be this moment, since you will not know when the next dip is.
But still, it is in human nature to at least try to wait until the next market dip. You feel you may overpay if you just rush out and buy an index fund right now. There is a sophisticated yet very simple strategy called dollar cost averaging that I find very useful in reducing the risk and anxiety. This strategy is also useful if, like most people, you do not really have a lot of cash lying around or you are new to this idea and would like to try out with small amounts of money at a time.
Dollar cost averaging goes like this. You set a fixed amount you want to invest in a selected index every month. If the price is high in a certain month, your fixed amount of money will buy a smaller number of shares. If the price is low that month, the same amount of money will buy more shares. So over long periods, the average purchase price of your holdings is less than the market average price. Table 1.1 is an example comparing dollar cost averaging (investing the same $ amount each month, say $1,000 a month) to the strategy of buying the same number of shares each month regardless of price (say 50 shares a month for this example).
This shows how dollar cost averaging gives a lower average price per share, hence a bigger profit. In fact, dollar cost averaging would still have generated a profit even if the ending price falls to $18 per share. Dollar cost averaging is even more profitable if there are significant temporary market slumps once in a while as shown in Table 1.2.
This is because the fixed, predetermined sum is able to purchase a greater number of shares during these times, hence reducing average per-share price and increasing profit in the long-term when market recovers. Therefore, dollar cost averaging requires perseverance during poor market conditions. Its advantages will be limited if it is only practiced during a strong market.
Again (I promise this is the last time I mention this in this book), I must emphasize that there is always a risk in any investment. Obviously, dollar cost averaging assumes a long-term appreciation (or a slight decline at most) of the stock market. While this has always been true before, it may not be true for overheated markets or for newly developed markets that may run into a major market correction that never recovers.
Table 1.1 Dollar Cost Averaging Example 1
Table 1.2 Dollar Cost Averaging Example 2
Notes
1. A stock split increases the number of shares outstanding by issuing more shares to current shareholders. Price per share is reduced accordingly, so the total value of all outstanding shares remains the same. For example, say a company has 1,000 shares of stock outstanding at $50 per share. The total value of the outstanding stocks is 1,000 × $50, or $50,000. The company splits its stock 2 for 1. There are now 2,000 shares and each shareholder owns twice as many shares. The price of each share is adjusted to $25. The total value is now 2,000 × $25 = $50,000, the same as before. Companies tend to split stock if the price has increased significantly and is perceived to be too expensive for small investors.
2. Thomas J. Stanley, The Millionaire Mind (Kansas City: Andrews McMeel, 2001), 135.
3. Robert T. Kiyosaki and Sharon L. Lechter, Rich Dad, Poor Dad (New York: Business Plus, 2000), 46.
4. V. P. Sriraman, “The Power of Compounding” Bharathidasan School of Management; available online: www.bim.edu/pdf/lead_article/compounding.pdf (access date: January 12, 2009).
5. George S. Clayson, The Richest Man in Babylon (New York: Signet, 1998), 21.
6. Conwell is best remembered as the founder and first president of Temple University in Philadelphia, Pennsylvania. His famous story, “Acres of Diamonds,” is available online: www.temple.edu/about/Acres_of_Diamonds.htm (access date: January 12, 2009).
7. Gary W. Eldred, The 106 Common Mistakes Homebuyers Make (New York: Wiley, 1995), 38–39.
8. Robert G. Allen, Multiple Streams of Income (New York: Wiley, 2000), 51.
9. Ibid., 54.
10. Ibid., 57.
11. Ibid., 53.
2
YOU CAN NEGOTIATE ANYTHING
YOU ARE CONSTANTLY NEGOTIATING
Like it or not, you are a negotiator. Negotiation is a fact of life. Governments negotiate treaties. Businesses negotiate deals and contracts. You negotiate with your boss on your salary. You negotiate with strangers to purchase a house, a car, or even just a T-shirt from a street vendor. You negotiate with your kids on how late they can stay up. You negotiate with your spouse on how often you should see your in-laws. Negotiation is the basic tool for getting a solution when you and the other side have some shared and opposing interests. HBs devotes much time to negotiation skills.
In this chapter, I highlight some of the key concepts taught at HBS, which I have found very useful in my personal and professional life. It is crucial to understand the other parties’ real interest and best alternative if they do not reach an agreement, to help reframe the context and terms of the negotiation. Once the stage is set, the key soft skills to get the other side to agree are careful listening and building a “golden bridge.”
UNDERSTAND THE OTHER PARTIES’ REAL INTEREST
This is a story I heard from an HBS classmate: Years ago, when China was negotiating to enter the World Trade Organization (WTO), one of the key barriers was whether China should enter as a developing or a developed country. China insisted on joining as a developing country, but a number of other countries disagreed. The two positions were incompatible and it appeared that one side would have to be forced or persuaded to yield. But a solution was made possible once the parties looked at the real interests behind these positions. China wanted to join as a developing country because of the more favorable terms such as slower pace of market liberalization and bigger subsidies to certain sectors. Other countries wanted more demanding terms in some sectors, mostly to protect their own interests. Once this was understood, then instead of arguing developing versus developed, negotiations were refocused on the pace of liberalization and sector subsidies. Instead of sticking to standard terms related to developing versus developed countries, WTO members and China were able to work out China-specific terms in each area.
Another example is this well-known incident cited in many negotiation books. In 1978, President Sadat of Egypt and Prime Minister Begin of Israel met at Camp David to negotiate a peace treaty. They had to agree on the boundary between their countries but they were deadlocked because their positions were incompatible. Both sides wanted the Sinai Peninsula, which falls between the two countries. No matter
how the boundaries were drawn and redrawn, no solution could be reached.
However a solution was made possible once the parties started looking at the real interests behind their positions. Egypt wanted sovereignty: Sinai had been part of Egypt since ancient times. Israel did not care about sovereignty over Sinai. It wanted Sinai because it did not want the Egyptian army to be anywhere close to the “real” Israeli border. It wanted Sinai to act as a buffer between the Egyptian border and the “real” Israel.
So although the positions were incompatible, the interests were not. In the end, a solution was successfully negotiated. Sinai was returned to complete Egyptian sovereignty but would be largely demilitarized to give Israel its military buffer zone.
These two examples illustrate the importance of understanding real interests. Then negotiation becomes a quest to find a solution that satisfies these interests as much as possible to get to a win-win situation. Failing to understand interests will result in “position negotiation.” Each side takes an opposing position (China wanted to enter WTO as a developing country and a number of other countries wanted it to enter as a developed country.) Then negotiation becomes a zero-sum game—one party wins only if the other party gives in.