Cale Smith, MBA
August 21, 2009
Q. What should I be looking for when I invest in stocks?
A. Let’s tackle this question in two parts. But first, a warning. Wall Street for all its flaws does employ some very bright people. Before you buy a stock, ask yourself if you really know more about it than the PhD hedge fund manager who’s about to sell it. Only one of you is going to have made the right decision.
Now, let’s turn that question on its head and ask, “How can I be absolutely sure I will lose money on the stocks I buy?” Here are five common ways people lose their shirts.
1 – Mistaking speculation for investment. As Warren Buffett’s mentor Ben Graham said in 1934, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
2 – Viewing a stock as a piece of paper. You cannot out-trade the professionals. Think of a stock as partial ownership in a business.
3 – Buying overvalued stocks. There is very little room for error when buying overvalued shares.
4 – Confusing noise with signal. Watching CNBC can be hazardous to your wealth.
5 – Thinking high growth means high returns. Growth can destroy value as easily as it can create it. In fact, I believe high growth is way overrated when investing. Here’s the math behind why I prefer a value investing approach.
Say Corley buys shares in a company for 50% of their intrinsic value, meaning the shares are really worth twice the current stock market price. Assume the company grows its intrinsic value 12% per year by doing nothing more than retaining its own earnings. Even if it takes four years for the market price to reflect the company’s true worth, her investment will still have compounded at 30% per year.
Mathematically, two thirds of that return comes from the gap between market price and intrinsic value closing. Only one third comes from the business value growing. So growth is essential when investing, but it’s less important than buying shares at a low price.