You have become a dedicated value investor, and now you want to get started at the actual investing.
You have seen the light.
You understand that it’s about buying shares when they are undervalued on the stock market and selling them when they are overvalued (or keeping them).
Congratulations. That’s actually an important milestone.
Maybe the concept seems obvious to you, but for many it’s not that obvious.
A lot of people never get it.
Most people think – and this is the dominant mindset in the market – that stocks always have the “right” price.
Most people believe the market is efficient. They believe that since all (or almost all) information is out there, all data is priced into the stock by the efficient machine called the market. Based on this, the logical conclusion is that whatever price the market decided to place on a stock is the right price.
There’s just one flaw in that line of thinking.
The market is not a perfect machine.
The market is made up of people making tons of decisions, and people are driven by emotions.
It’s about as efficient as a crowd at the town square. One moment throwing rotten eggs and the next moment throwing flowers.
People are driven by all sorts of emotions, including fear and greed, which are the dominant emotions in the stock market.
Prices sometimes fall below a logical level because people get scared out of their wits, and other times prices soar above any logical level because they get caught up in greed and don’t want to miss out.
Not all people get the idea behind value investing.
Warren Buffett said value investing is like buying a dollar for 50 cents. He also said that some people catch the idea right away, while others don’t.
If someone doesn’t get it, you can explain it for days on end, but they will never understand it (according to Warren Buffett).
In other words, you’re one of the chosen who get it – and that’s not something to take for granted.
Be grateful for that.
The Big Value Trap
So what’s the mistake that lots of newbie value investors make?
I believe they haven’t completely let go of the idea that the market is efficient. They basically believe that it’s effective… but that it occasionally slips.
When they see a stock dip, they immediately assume it’s on sale.
You often hear people say something like “stocks are on sale” when the major indices fall 2%. Then they buy left and right without looking into what they’re buying shares in.
But what if the dollar that Warren Buffett talks about has been pumped up by greed for 12 years and has become $10? Is it on sale for $9? Not at all.
Some people use the term “falling knife.”
A falling knife is when stocks in a company are in steep decline but have much longer to fall before they stabilize.
If you try to catch a falling knife, you’ll cut your hand open. It’s a bloody mess. You have to wait for the knife to hit the floor.
You can also imagine that you’re jumping onto a roller coaster just as it’s twenty inches from the top and twenty feet from the bottom.
This picture is a little less bloody, but it describes the – uncomfortable – feeling in your gut when you buy something that keeps falling.
You can’t count on the rolling coaster going up again… and then it’s money you’ll never get back.
How to Avoid the Trap
So what can you do to avoid these value traps and falling knives?
It’s a bit like the annoying doctor who tells you there is no way around it: you need to exercise and eat vegetables.
No pill can fix it.
Maybe that’s not so bad.
For many of us, exercising and eating fresh vegetables is an enjoyable part of our lifestyle. The same with investing.
What does this mean in stock language?
It means that there is no quick fix where you can just look at a chart on your screen and expect to know that something is cheap because the stock price has fallen.
The first thing you have to figure out is whether it’s broken or not.
You don’t want to invest in something that’s going into chapter 11.
You have to look at the reality of the company. You have to go through a checklist and ask some critical questions so you are sure you’re buying stocks in a healthy company with a good team of managers and strong products that can compete in the market.
Once you’ve figured that out, you can look at the numbers to see what it’s really worth.
It may sound difficult, but it is not.
There are pretty simple calculations that anyone can learn and that are easy enough to do on the back of a napkin.
If you want to learn more about that, download my free e-book here.
Don’t forget to download my e-book Free Yourself where you’ll learn about check list and simple value calculations. You can download it here.