Posted: 12-12-24 | Zach Terpstra
A balanced life requires discipline—regular exercise, a nutritious diet, and a clear set of values that steer us away from harmful behaviors. These habits act as guiderails, keeping us aligned with the outcomes we desire. Occasionally indulging in a small cheeseburger is unlikely to derail your health, as a well-defined routine and value system help maintain focus on long-term goals. The same principle applies to investing: discipline and structure are essential for sustaining a healthy portfolio over time.
Most of us are not great at picking stocks. Professional investors are not exempt from this generalization. Active managers of equity portfolios tend to see their performance fall victim to mean reversion over time. As time moves on, we expect most stock picking strategies to perform near or below their benchmark. Why is almost everyone, irrespective of skillset, bad at picking individual investments?
Biases in Investing
As the saying goes, “Garbage in, garbage out.” In today’s information-rich environment, data is widely available, but its quality and reliability are often compromised. Each time a person interacts with data, it becomes subject to that individual’s biases and ideologies, making it more likely that what you are hearing is not precise, but rather warped to that specific person’s interpretation. Let’s imagine you are reading a stock analysis from a well-known Wall Street analyst to inform you whether to invest in FakeCo after its most recent quarterly earnings call. Before you base an investment decision based on this information, it has already been influenced by:
- FakeCo’s internal analysts, who aggregate the data.
- FakeCo middle management team who edit the report
- The executive team who finalizes the presentation
- Analysts attending the earnings call who interpret the results
- Analysts who revise and publish their analysis
- Compliance and marketing teams who ensure the report is aligned with firm goals.
By the time you read the report, six different parties have shaped the information. Each has their own agenda or perspective, potentially distorting the data. This demonstrates why relying solely on reported information is insufficient to justify a stock purchase. Successful investing requires critical thinking: sifting through data, minimizing biases, and interpreting information to form a realistic forecast.
Margin of Safety
Even with careful analysis, there is inherent risk when evaluating investments. What if your analysis is flawed, or you lack the expertise to confidently estimate a fair purchase price? Many authors have written on how to properly account for unknowable risks when self-selecting stock investments. Ubiquitously, most value investors have come to know this practice as introducing a “Margin of Safety” into their investment ideas. This practice involves discounting from the original target price based on our perception of risk, including risk which is derived from unfamiliarity.
For example, after analyzing FakeCo, you might conclude the fair value of its stock is $100. However, if the stock trades at $99, the 1% margin of error may feel too slim to justify an investment. Acknowledging the uncertainties in your analysis, you might decide to only buy at $60—or even $40, if you’re particularly cautious. The goal is to factor in both the company’s risks and your own limitations as an investor.
Evaluating Risk in a Changing Market
Valuation when picking stocks should not only factor in your growth expectations; you must also acknowledge the risks associated with the underlying company and your expertise. Applying this view to the broader U.S. markets, most indexes are overvalued by historical standards in consideration of future growth.
Figure 1: S&P Valuation Measures, JPM Guide to the Markets 10/31/2024
Given this context, stock picking is likely harder today than it was in years past. The most familiar names in the U.S. market are trading at elevated valuations, and finding stocks with a healthy margin of safety often requires extensive research and unconventional thinking.
Long-Term Investment Success
The good news? No one is forcing you to pick stocks in an overvalued market. Just as you can pass on that tempting cheeseburger, you can also choose to wait for better opportunities. Investing should always align with your long-term goals and your portfolio’s ability to absorb additional risk.
Patience, discipline, and a well-defined strategic framework are your best allies in navigating today’s market. Remember: the goal is not to chase every opportunity but to make decisions that keep your portfolio healthy and on track toward its ultimate purpose.
Take the first step to a healthy portfolio. Schedule a 15-minute introductory call to learn how we can help you navigate today’s market with confidence and