Although value investing properly executed is a low-to-medium-risk strategy, it still comes with the possibility of losing money. This section describes the key risks to be aware of and offers guidance on how to mitigate them.
- Basing Your Calculations
on the Wrong Numbers
Since value investing decisions are partly based on an analysis of financial statements, it is imperative that these calculations be performed correctly. Using the wrong numbers, performing the wrong calculation or making a mathematical typo can result in basing an investment decision on faulty information. Such a mistake could mean making a poor investment or missing out on a great one. If you aren't yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don't place any trades until you're truly ready.
- Overlooking Extraordinary Gains or Losses
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company's financial health. The problem with financial ratios is that they can be calculated in different ways. Here are a few factors that can affect the meaning of these ratios:
- They can be calculated with before-tax or after-tax numbers.
- Some ratios provide only rough estimates.
- A company's reported earnings per share (EPS) can vary significantly depending on how "earnings" is defined.
- Companies differ in their accounting methodologies, making it difficult to accurately compare different companies on the same ratios. (Learn more about when a company recognizes profits in Understanding The Income Statement.)
One of the biggest risks in value investing lies in overpaying for a stock. When you underpay for a stock, you reduce the amount of money you could lose if the stock performs poorly. The closer you pay to the stock's fair market value – or even worse, if you overpay – the bigger your risk of losing capital. Recall that one of the fundamental principles of value investing is to build a margin of safety into all of your investments. This means purchasing stocks at a price of around two-thirds or less of their inherent value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.
Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his "Little Book of Value Investing." Famous value investor Benjamin Graham suggested 10 to 30 companies is enough to adequately diversify. On the other hand, the authors of "Value Investing for Dummies, 2nd. ed.," say that the more stocks you own, the greater your chances of achieving average market returns. They recommend investing in only a few companies and watching them closely. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.
It is difficult to ignore your emotions when making investment decisions. Even if you can take a detached, critical standpoint when evaluating numbers, fear and excitement creep in when it comes time to actually use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you may be tempted to sell it if the price falls. You must remember that to be a value investor means to avoid the herd-mentality investment behaviors of buying when a stock's price is rising and selling when it is falling. Such behavior will destroy your returns. (Playing follow-the-leader in investing can quickly become a dangerous game.
After the accounting scandals associated with Enron, WorldCom and other companies, it would be easy to let our fears of false accounting statements prevent us from investing in stocks. Selecting individual stocks requires trusting the numbers that companies report about themselves on their balance sheets and income statements. Sure, regulations have been tightened and statements are audited by independent accounting firms, but regulations have failed in the past and accountants have become their clients' bedfellows. How do you know if you can trust what you read?
Comparing a company's stock to that of its competitors is one way value investors analyze their potential investments. However, companies differ in their accounting policies in ways that are perfectly legal. When you're comparing one company's P/E ratio to another's, you have to make sure that EPS has been calculated the same way for both companies. Also you might not be able to compare companies from different industries. If companies use different accounting principles, you will need to adjust the numbers to compare apples to apples; otherwise you can't accurately compare two companies on this metric
Even if you do everything right in terms of researching and purchasing your stocks, your entire strategy can fall apart if you sell at the wrong time. The wrong time to sell is when the market is suffering and stock prices are falling simply because investors are panicking, not because they are assessing the value of the quality of the underlying companies they have invested in. Another bad time to sell is when a stock's price falls because its earnings have fallen short of analysts' predictions.