Value investing, properly executed, is a low-to-medium-risk strategy. But 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.
- 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.
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 not earning money or even losing capital. Recall that one of the fundamental principles of value investing is to build a margin of safety into all your investments. This means purchasing stocks at a price of around two-thirds or less of their intrinsic value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.
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 may 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 behaviours of buying when a stock’s price is rising and selling when it is falling. Such behaviour will obliterate your returns
After the accounting scandals associated with Enron, WorldCom, Tesco, Toshiba 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 some unethical accountants have become their clients’ bedfellows.