Logic should be at the heart of every investor’s decision-making process, yet many go wrong in a variety of ways. Chasing performance, failing to diversify, buying stocks without doing even a modicum of research and giving into cognitive biases conspire to keep millions of portfolios down – and of course there are the usual advertisers and “money managers” who try to convince anyone who will listen that they have the best plans and strategies to attain stock market riches.
So what can the average investor, and more importantly, you, do to avoid these illogical traps and obtain superior results?
The answer is simple: Be like Spock. Put a proven, logical, mechanical investment system into place and then follow it.
For example, when markets are falling and fear is everywhere, the good stocks tend to plummet along with the bad ones. These are times of fantastic opportunity because you can usually find a host of great companies selling for very low prices.
However such overarching market opportunities, such as were available during the Global Financial Crisis of 2007 and 2008, are rare and far between. But you don’t need to find scores of great, low-priced, inexpensive companies to create a terrific portfolio.
You just need a handful.
And those are available practically all the time as certain industries or individual companies fall out of favour and lose market value at, sometimes, astounding rates.
Of course not all stocks that fall in price are good buys. In the majority of cases there are good reasons why prices have fallen. The trick is to learn how to differentiate between great stocks that are selling for bargain prices based on no logical reason and the rest of the bunch that are cheap because of very real and logical reasons.
Now there are many ways to ferret out great stocks, but for those wanting a simple method to winnow down the thousands of candidates to a manageable number, we need only go back to Benjamin Graham’s classic book, “The Intelligent Investor.”
Ben Graham’s Tests for Good Stocks
Graham described two tests. Both are easy to do because the necessary data are readily available online at sites such as Yahoo! Finance, Google Finance and MSN Money.
The first is to find stocks trading at low price-to-earnings (P/E) ratios, because you’re paying relatively little for each dollar in earnings.
The second test is to find stocks with low price-to-book-value (P/B) ratios, because you’re paying very little for the companies’ assets.
These two tests can filter out literally thousands of overpriced stocks. However you shouldn’t stop there. Low P/E and P/B ratios can, and usually do, indicate there’s a problem with the company. After all, the market, as a whole, has voted to run away from these companies and usually there is a valid reason. However that’s not always the case, sometimes the market is wrong and punishes a stock for no good reason. These are the opportunities you should be looking for.
The idea is to reduce the number of stocks you need to analyze so you can concentrate on doing a thorough job by looking at a few companies rather than doing a half-baked job analyzing many companies.
Determine why the company is selling so inexpensively. Is it because the market is focusing on sub-par results from the last quarter and ignoring a company’s phenomenal long-term prospects?
In addition, there are other tests you can subject stocks to that determine their fundamentals strength as well as their economic moat strengths.
But by starting with these two simple ratios, doing some further research and diversifying correctly, you have a good chance to outperform the markets. In their paper, Returns to Buying Earning and Book Value, Stephen Penman and Francesco Reggiani, reported that from 1963 to 2006, investors who selected low P/E and low P/B stocks would have outperformed the market by more than 13% annually. That’s an amazing result.
Granted it would not have been feasible for the average investor to hold all such stocks in his or her portfolio, but using P/E and P/B to filter out expensive stocks and then analyzing the remainder for strong fundamentals and wide moats should nevertheless provide stellar returns in the long run.
So before you risk your hard-earned money in the stock market, take a moment to find a proven system based on Spock-like logic. Then follow it regardless of what everyone else is doing.