Investing Is Hard Enough: Here Is How To Avoid Making Obvious Mistakes

<< Read Part 1: Answering the Important Questions: When to Buy or When to Sell A Stock
<< Read Part 2: Principles of Valuation: Price Is What You Pay, Value Is What You Get
<< Read Part 3: The Right Way To Value Growth Stocks

The Key to Avoiding Obvious Mistakes

Understanding how to value a business is the key to avoiding making obvious mistakes when purchasing or selling common stocks. When you know what your investment is worth, the market cannot take advantage of your gullibility. When you don’t know what your investment is worth, markets can easily influence you with fear or greed. When emotions rule, logic goes out the window. This series of articles has been focused on helping the reader understand what fair value is, how it’s calculated and how it can be used to be a smarter and more successful long-term investor.

A second key is to recognize that these principles apply to long-term investing. As Ben Graham so aptly put it “in the short run the market is a voting machine, but in the long run, it is a weighing machine.” The critical aspect of Ben’s profound statement is to accept the reality that the market can and will miss price stocks over short periods of time. On the other hand, it is also a reality that the markets will improperly value stocks over several years. This often is what gets investors in trouble.

However, true prudent value investors recognize that inevitably a company’s stock price will move into alignment with its true worth valuation. It is not a matter of if, but only of when it might occur. Smart investors recognize anomalous values and are prepared to take appropriate action as they occur. This could mean being aware, and therefore, being prepared to take action, or it can also simply mean taking immediate action. Nevertheless, it’s the awareness that is the key to long-term success.

Principles of Valuation Part 4:

In this, my final installment of my series of articles on when and why to buy a stock, I will focus on how to use the principles of valuation to avoid obvious mistakes. As mentioned in previous articles, investing is never a game of perfect. The best that an investor can hope for is to make sound long-term decisions, with most of them working out to their benefit in the end.

However, investing is a very complex endeavor, and mistakes are inevitable. Therefore, it’s imperative that the obvious mistakes – which can and should be avoided – are avoided.

Obviously, mistakes usually occur when the market or people are caught up in emotion. As we all know, the primary emotional responses that can affect investor behavior are fear and greed. When gripped by the hype from greed or by the hysteria from fear, investors rarely behave rationally. It is during times like these when stock prices can become disconnected from true worth valuations. This undeniable fact that stock values are not always rational needs to be recognized and accepted.

In my opinion, one of the primary reasons why investors often make bad investment decisions is because their judgment is usually based only on price movement. As I will illustrate, price movements alone can be very misleading. A rising stock price will often lull an investor to sleep creating a false sense of security where they believe that all is well.

On the other hand, a falling stock price usually creates anxiety and sometimes leads to outright panic. These feelings can only be rational if they are justified by sound fundamentals. Knowing the differences between rational and emotional reactions will make all the difference, as the following examples will illustrate.

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Disclosure: Long CSCO and CVS

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the ...

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