Value investors essentially compare a company’s intrinsic value with its stock market price and attempt to buy into companies whose stocks are under-valued. For example, say Widget, Inc.’s stock is selling for $10 a share. A value investor might research Widget, Inc. and decide that the company’s overall performance indicators mean the stock will increase in value. However, things don’t always work out that simply.
Determining the intrinsic value of a company is not a clearly defined process; different investors have their own criteria. Some investors may “miss the mark” by overestimating how well a company is doing. Even highly experienced investors can easily misread performance indicators.
Assessing the right time to buy according to what’s going on with a company in comparison to its stock prices can be tricky. Unlike market timers who buy based on stock market timing, a value investor may perceive value in some new development that may or may not work out.
Not Enough Margin of Safety
Buying low-priced stocks should theoretically reduce investors’ risks. However, if you miscalculate the amount the stock will go up, you may not see the returns you’re looking for. Additionally, just because lower priced are less risky, that doesn’t mean they can’t drop in value.
Underestimating the Efficient-Market Hypothesis
Research done by Shailesh Kumar at Value Stock Guide suggests most value investors don’t believe that the efficient-market hypothesis, the idea that stock prices accurately reflect all the information about a company, is correct. That may be true sometimes, but that doesn’t mean the market is always wrong either. Figuring out the truth isn’t always easy.
Following the Pack
One of the keys to successful value-investing is knowing for certain when a company has solid principles and financials. Investors who decide to follow market trends and buy or sell when everyone else is doing the same can easily get burned by not having faith in what they know.
Not Having Patience
Value investing isn’t always a buy and hold strategy, but often it takes time for your research into a company to pay off. If an investor loses confidence in a stock because its price is rising as quickly as he or she hoped, the investor may end up selling too soon and not seeing a profit.
Going for a Better Deal That Doesn’t Work Out
Some value investors decide to sell one stock for another because it looks as if it has the potential to yield a better turnover. Sometimes this works out, sometimes it doesn’t. There are occasions where the stocks you sell might wind up being “the ones that got away.”
Like any investing strategy, value investing has its own pros and cons. Some value investors, such as Warren Buffet, have been famously successful. On the other hand, many others have found that determining the intrinsic value of a company is a daunting task. As an investor, your best bet is to assess your own capabilities and, if you do decide to be a value-investor, avoid these common pitfalls.