I started managing my current portfolio nearly 5 years ago. At the time of writing (December 8, 2024), my portfolio has returned 328.89%, with an annualized return of about 35.94%.

As someone who graduated with a degree in Finance and Economics back in 2014 from the Great Grand Valley State University, it took me way too long to apply the things I learned and start actively managing a portfolio. It hasn't been all sunshine and rainbows, but I’ve learned a few things along the way. I’d like to share two simple, but powerful ideas that I wish I understood more deeply when I started out. 

A lot of people will overlook what I’m about to say because they’ve heard the words before. I implore you to read with a beginner’s mind.  I promise...a deeper understanding makes all the difference and can literally change the way you see everything around you. 

The first idea we have to understand might seem obvious, but it’s critical to go over because it sets the foundation for how we make decisions when it comes to investing. It helps us determine a good investment from a bad one, and it provides clarity on what we’re actually doing when we’re investing in the stock market. It reduces anxiety and grounds our thinking in a useful way.  

It all starts with a simple question: What is a stock?

Ridiculous…I know, but can you answer the question without looking it up? Most people can’t. And if they can, it’s usually missing context. It’s not described in a way that can provide a practical framework for decision making. 

But before we can answer that question, we have to ask a deeper question: What is a company?

Simply put, a company is a group of people working towards a specific objective. If business is the art of staying busy in a profitable way, then in business, a company is a group of people who are staying busy in a profitable way. A stock is ownership in a company...so when we buy stock, not only do we own part of the company, but we earn with the company. That’s what makes a stock an asset. The underlying value is in people doing profitable things.

I want you to picture 5 of the smartest, most ambitious, hardworking people you know. The hustlers, the creatives, the nerds etc. Now imagine they form a company, you invest in this company, and they go on to release a product or service that solves a real problem in the world. Imagine it becomes wildly successful. By owning stock in this company, you also own a share of its earnings. 

This brings us to the next idea. We pay for food, we pay for coffee, we pay for clothes, we pay for technology. Almost everything has a price. And just like the other items we purchase, the price of company ownership fluctuates based on how much someone is willing and able to pay for it. In the stock market, where people buy and sell different stocks, this happens in real time.

It's important to note that the price doesn't always reflect the value of what we're buying. Sometimes we pay more than we would have liked for something we initially thought was valuable but ultimately wasn't, and other times we get something that ends up being really valuable for a discount. So what makes something valuable in the stock market? To keep things simple, we'll say the value in a company lies in its earning potential.

This means that what we get for the price we pay is earning potential. Let's make sure we're on the same page with a quick, crude example. Let's pretend there's a stock market around the corner and at this market there's one person selling their stock in Company A and another selling their stock in Company B. Both are selling their shares for $20. If Company A is earning $1 per share and Company B is earning $5 per share, who's presenting the better deal? All things equal, it would be the person selling their stock in Company B because Company B is currently earning more at the $20 price point.

The comparison between price and earnings is known as the P/E ratio, and good thing for us, it's widely available for all publicly traded companies. It's important because it allows us to ask deeper questions about what we're buying.

Historically the P/E sits between 20 and 25, meaning a publicly traded company is usually priced at 20-25 times what it's currently earning.

When we look up a company and discover the P/E ratio is 100, that means we’d be paying $100 for every dollar that company is currently earning. If we look up a company and find the P/E ratio is currently 5, that means we'll be paying $5 for every dollar that company is currently earning.

As investors, our job is to ask why?

It can be helpful to think about the relationship between price and the value we get from a purchase in the context of other markets. At the farmer's market, if the price per pound of meat is $20 at one seller, and the price per pound of meat is $4 at another seller, all things equal, who has the better deal? I'll let you figure this one out ;).

Back to stocks.

These ideas are only starting points, but as fundamentals, they go a long way. Now that you understand what a stock is and how much it costs, you should find your research being more focused on what you’re buying and what you’re selling, and less focused on when to buy and when to sell. You're intuition will become sharper. Timing is a function of understanding.

If you found any value in this join my Constants community or find me in the Constants Finance community.

My Community: https://www.constants.com/u/tendo
Finance Community: https://www.constants.com/c/finance