Value investing principles

Value investing works.

Whether you look at academic research, or successful value investors like Warren Buffett, or examine it from a behavioral finance perspective, or just understand it intuitively, value investing is an investing discipline that beats all other methods (that I’ve examined).

The ideas behind value investing aren’t very complicated, but can be difficult for people to grasp:
1) a business has a value that can be determined
2) part of that valuation is based on an unknown future, so you want to buy far below assessed value
3) buying below value–with a margin of safety–reduces the cost of errors due to a) judgment, and b) an unknowable future.

The concept, then, is to value a potential investment and then compare that value to the price one can buy it from the market–its stock price. If the price is significantly below value, you should buy it. If the price is equal to or above assessed value, you shouldn’t buy it or you should sell it.

That’s it in a nutshell, but it’s more complicated to implement than that, and the main reason is psychology.

It’s very difficult for people to buy something going down in price because 1) it’s almost always cheap for a good reason, and 2) they think it will keep going down in price. Also, it’s difficult to sell something that’s gone up in value because people tend to think it will keep going up.

This psychology is the main reason, in my opinion, why most people either don’t get or can’t apply value investing principles.

Value investing also seems counter intuitive to a lot of people. They can’t stand buying what isn’t doing well, regardless of price to value. They want to buy what’s hot, not what’s not.

I’ve tried to explain value investing principles to many people over the years, and they either get it or they don’t. If they get it, you can see it in their eyes. If they don’t, they tend to say, “but…but…but….”

I say things like, “it’s not an issue of whether a $150 sweater is better than a $50 sweater, it’s an issue of whether you should buy a $150 sweater selling for $200 or a $50 sweater selling for $25.”

People who get value investing quickly grasp that analogy. People who don’t, don’t. In fact, they tend to reply, “But…but…but…the $150 sweater is nicer.” To which I reply, “For $200?”

The cold, hard fact is that people who pay $200 for $150 stocks get lousy returns, and people who buy $50 stocks for $25 build wealth over time.

The evidence supports that proposition quite convincingly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.