Ascertaining an asset’s intrinsic value is hard. But it’s even harder to determine that something is undervalued and to buy it at its absolute low. In fact, it’s impossible to know exactly when a security has bottomed out. In almost every case, a value asset will continue to fall in price after you have bought it. In his book, "The Most Important Thing," value investor Howard Marks (Trades, Portfolio) discusses the problems that come with buying value.
Being too far ahead of your time
As value investors, we can (sometimes) determine whether something is selling below intrinsic value, but not how much lower it will go:
“Let’s say you figure out that something’s worth 80 and have a chance to buy it for 60. Chances to buy well below actual value don’t come along every day, and you should welcome them. Warren Buffett (Trades, Portfolio) describes them as “buying dollars for fifty cents.” So you buy it and you feel you’ve done a good thing.
"But don’t expect immediate success. In fact, you’ll often find that you’ve bought in the midst of a decline that continues. Pretty soon you’ll be looking at losses. And as one of the greatest investment adages reminds us, “Being too far ahead of your time is indistinguishable from being wrong.” So now that security worth 80 is priced at 50 instead of 60. What do you do?”
Now, if you know for sure that the asset is being mispriced then further declines should not be an issue. The cheaper something gets, the better of a bargain it is, so you should buy more. Of course the problem is that nothing is ever 100% certain. Indeed, you must always be open to the possibility that you could be wrong in your assessment of the situation. So it is only natural that investors become skittish when their positions continue to decline:
“This makes it very difficult to hold, and to buy more at lower prices (which investors call “averaging down”), especially if the decline proves to be extensive. If you liked it at 60, you should like it more at 50 . . . and much more at 40 and 30. But it’s not that easy. No one’s comfortable with losses, and eventually any human will wonder, “Maybe it’s not me who’s right. Maybe it’s the market.” The danger is maximized when they start to think, “It’s down so much, I’d better get out before it goes to zero.” That’s the kind of thinking that makes bottoms . . . and causes people to sell there.”
Don’t be stubborn
The value investing philosophy is in large part based on the idea that humans are not perfectly rational machines, and that they are subject to various cognitive biases. One of these biases is the tendency to follow the crowd and jettison contrarian investment positions. It’s easy to deride such behaviour as "weak-willed," but sometimes stubbornly sticking to a bad thesis is much worse than not believing in a good thesis. As Marks puts it:
“An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse. This one statement shows how hard it is to get it all right.”
We often talk a lot about how important it is to stick to your guns in the face of the consensus view, but not as much about how important it is to know when to give up. You gotta know when to hold them, know when to fold them.
Disclosure: The author owns no stocks mentioned.
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