It has never been easier to be an investor. Over the past few decades, the cost of trading and opening an investment account has plunged, and the number of tools available to individual investors has also dramatically increased.
Now anyone can go online and look at company fundamentals and research businesses with just a few clicks. There are plenty of websites devoted to visualizing data and helping investors value securities with minimal effort.
These tools can be beneficial, but they can also be detrimental to performance, in my opinion. The constant influx of information can obscure what's important and cause investsors to make certain types of errors.
Seeing red
Most online brokerage accounts show investors how much money they are making on individual positions. They can also detail returns over a set period, and any impact fees may have had on overall profits. Once again, these tools can be helpful. However, some are designed to make investors trade more so that the broker can earn a higher profit.
For example, if I own a position worth $10,000, and the value of that position drops to $8,000, platforms that show profit or losses on positions may illustrate this with a red font and a "-$2,000" sign. Mathematically this is accurate, but red is associated with danger, and we know the psychological bias of loss aversion means humans feel losses twice as much as they appreciate profit.
Therefore, by highlighting the loss in red and making the loss prominent, the platform could be encouraging investors to take action. The same is true of profits. If investors can see a significant profit on a position, they could be encouraged to sell and book the profit.
Investment buy or sell decisions should not be based on how much profit or loss an investor has made on a particular position. Instead, they should be based on sound judgment and analysis of the fundamental performance of the underlying security.
One way to get around some of the issues highlighted above is to ignore the purchase or book value of the stocks in one's portfolio. Warren Buffett (Trades, Portfolio) illustrated this principle in 2009. When he was asked how he'd manage a portfolio of equities, some of which had increased in value dramatically, he said:
"We would own the half of dozen or so stocks we like best...it wouldn't have anything to do with what our cost on them was. It would only have to do with our evaluation of their price versus value. It doesn't make any difference what the cost is. And incidentally, if they went down 50%, we would say the same thing... The cost basis doesn't have anything to do the fund. When Charlie and I ran funds, we didn't worry about whether something was up or down. We worried about what it was worth compared to what it was selling for."
Value and price
This principle makes sense in all market environments, but it is imperative in times of market turbulence. Looking at the market value compared to the cost value of securities can be an incredibly misleading way to judge value. All this figure tells an investor is how much profit or loss they are making on the position.
It does not tell them how much the company is worth, nor how much it could be worth considering its competitive advantages and growth potential. It is just a number, a snapshot of when the security was acquired and at what price.
What's more, if investors use the margin of safety principle, the purchase price will be far below the company's actual intrinsic value. And if that is the case, then why would one ever compare this figure to the amount of profit or loss on the position? The margin of safety is designed to compensate for unknowns. It is an imprecise number for this reason. Therefore, basing a trading decision on a number that was designed to be imprecise in the first place does not make much sense at all.
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