This article is contributed to us by Chris Lee Susanto.
Value Investing is a stock investing methodology that is practised by many successful investors, including Warren Buffett and Seth Klarman.
In Value Investing, you are essentially buying a stock that is worth $1 for 50 cents. There are many reasons why this can happen.
One of the reasons is that many stock investors do not understand what they are investing in. This forces them to sell a good stock at a cheap price when the market turns against them. This is when the practitioners of value investing will take advantage by buying the stock that are cheap.
You should also note that value investing is fundamentally different from stocks trading. While the latter focuses more on price movements and other technical indicators, the former focuses on analysing the business behind the stocks and buying the stocks at a cheap price.
Value investing also generally has a longer time span than other kinds of investing. That is because it generally employs a buy and hold strategy until the value of the investment plays out.
Value Investing Works Because Simply Put, The Stock Market Is Not Efficient
This means the stock market does not always accurately reflect the true value of the stock.
Someone who practices Value Investing would usually shun away from ridiculously priced stocks, even though the underlying business is good. Always remember that a really good business at an expensive price would still constitute a bad investment.
Often, stocks that look cheap via metrics such as price to earnings ratio or other indicators may not be really “cheap”. There are risks that the earnings of the business will continue to drop and as a result, the price of the stocks may drop further. This is a trap that we must look to avoid.
Value Investing Has Been A Passion Of Mine For As Long As I Can Remember
In my free time, I always research on ways to make more money – but on top of that, how to make money work for me.
I began reading more about value investing and realised that the father of value investing is Benjamin Graham and his disciple, Warren Buffet, is the second richest man in the world.
I’ve always idolised Warren Buffett and Benjamin Graham for their teachings in Value Investing simply because they have a very logical way of approaching stock investing.
I was surprised that value investing does not require exceptional intellect in the sense that anyone can learn it easily. Your mindset is more crucial to your investment success rather than your knowledge.
You need be patient and willing to go against the crowd. You should not borrow money to invest and only invest money you can afford not to use for the next 5 to 10 years.
I am a conservative person that only invests in the stocks of a good business– provided the price is attractive, in relative to the true value of the business.
This is done through value investing which is done using fundamental analysis plus patience in holding stocks for long term.
At the end of the day, we need to understand our investments before deciding to invest. Otherwise, it is simply speculating and we are bound to lose money– in the long run– the only time span that truly matters in investing.
What Is Behavioural Finance?
Behavioural finance is a study which seeks to explain why people make irrational financial decisions– especially in the stock markets.
Professor Rober Shiller is a famous professor who is very well-versed on the topic of behavioral finance, in fact, he recently voiced out concerns about the overvaluation of the US stock market.
There is a few psychology theory that is linked to behavioural finance:
1) Prospect theory is a theory of how people form decisions on uncertainty. It says that people estimate gains and losses from the reference point which is subjective and subject to manipulation.
People are more affected by small losses and less encouraged by small gains. This allows business to exploit people. In investing, people estimate gains and losses from the price they bought the stock at and are always more affected when their stock price goes down as compared to when their stock price goes up.
2) Regret Theory is people’s fear of the pain of regret. You may make bad decisions because you overly worry about regret. We may not want to sell off our stocks even if that is the correct thing to do because we may be afraid that we would regret it.
3) Overconfidence theory found that there is a human tendency to overestimate their ability. Most of us think we are above average. This is a problem because if we are too confident of our investment idea and get complacent, we might be missing out on other key things that we do not know about.
4) Cognitive dissonance is a judgmental biased people tend to make because they don’t want to admit they are wrong. We tend to cling on to old investment belief and find evidence that supports our beliefs. We have an exaggerated impression and forget the evidence that is contrary to our thesis and only finds the one that supports our investment theory.
5) Social psychology says that people are interdependent which is also known as herd behavior. This does not happen consciously. Our opinion of what is happening is formed as a collective sharing of information. Herd behavior creates big swings in the stock market.
How Is Behavioral Finance Linked to Value Investing?
In Value Investing, we are banking on buying the stocks of businesses that are trading below its intrinsic value or also known as real value.
Greed’s And Fear’s Influence on Investors
Greed. When the investor has made good gains on their investment, they refuse to sell the stocks because they are greedy for more gains. When there is evidence that says that a particular stock is overvalued, they look for evidence to support their beliefs that it is not overvalued– and thus, continue to hold it.
Fear. You bought a stock and it fell below the anchor point– the price you bought it at. You feel scared that it will drop some more but you will not sell it because you are afraid you will regret it if it goes up after you sell it. Again here, you look for evidence to support your belief that the stock price will rise above your buying price. But the stocks continue falling and you refuse to admit your mistake.
This article can be summed up with the biggest lesson being that we need to learn to think independently, instead of merely following the crowd.
We should understand the impact of human behaviour in the stock market, and hopefully, via that understanding, we would be able to invest in good value stock by being patient in focusing on the long-term investment results, instead of short-term market fluctuations.
Focus on our investment process and results will come – over time.
Chris Lee Susanto is the founder at Re-ThinkWealth.com, a value investing and options selling blog established in 2015 and based in Singapore.