Emotional Investing Vs. Intelligent Investing

Foreword from ShareInvestor

This article “Emotional Investing Vs. Intelligent Investing!” by Robert Tay was first published in the Dec 2010 – Jan 2011 Issue of INVEST magazine and is reproduced in this blog in its entirety. The article discusses about the merits of Fundamental Analysis in identifying undervalued gems in the stock market whereby the stock is trading below its intrinsic or perceived true value so as to make profit at the point of purchasing the stock. Click here for more details on a two-day course to be conducted by Mr. Robert Tay over this coming weekend, 21st & 22nd July 2012 where he will share with you how to “Create A Secondary Income Stream Through Strategies For Investing In The Stock Market”.

In the last 30 years of teaching investment courses titled “Strategies for Investing in the Stock Market” and having taught about 30,000 students in Singapore and about 50,000 students regionally, I have studied my students and made a very salient observation to say that most, if not all stock market participants are very “price centric” as opposed to being “value centric.” If you do not believe me, try out this little experiment.

Firstly, name 2 stocks that you own and secondly, give me their prices. I am sure you will have no problem in obtaining the prices from the newspapers, teletext or your broker. However if I were to ask you to ascertain the value of your 2 stocks, you may have difficulty in telling me their values. This is because most stock market participants are not knowledgeable or trained to calculate the value of a stock.

You may know the price of a stock but do you know its value? Price is what you pay. Value is what you get.

Price ≠ Value

Now let’s go through an exercise that I compel my students to undertake and they never fail to be surprised by the subsequent paradigm shift. Enjoy the paradigm shift and you will be more successful in your investment endeavours. Run through the exercise in a step by step approach.

  1. First, imagine that you have bought stock A
  2. The price of stock A has gone up! How do you feel? Happy, right? Also greedy in that you want the price to go higher? (See Diagram 1)

  3. The price of stock A has fallen! How do you feel? Sad, right? Also fearful that the price may fall further? (See Diagram 2)
    The words “Happy, Greedy, Sad, Fearful” are emotions.
    When you focus on price, you are driven by emotion!
  4. Now imagine that you are able to ascertain the value of Stock A and you now draw in a Value line. (See Diagram 2) 
  5. Now refer to Diagram 3 and you will note that the emotions have changed to be diametrically opposite. Where you were once happy and greedy because prices have gone up, you are now sad and fearful, because your stock is now overvalued. Where you were once sad and fearful, you are now happy and greedy because your stock is now undervalued and you want to buy more greedily.

More importantly you realize two observations that form the cornerstone of Intelligent Value Investing

  1. When the price of your stock is below its value line, there is a margin of safety. This is the first cornerstone.
  2. When you buy your stock at a price below its value, you have encountered the second cornerstone of Intelligent Value Investing – the profit is made in the buying.

When you focus on value, you are driven by intelligence.

Remember!

When you focus on price, you are driven by emotion. When you focus on value, you are driven by intelligence.

Great! So how do we value stocks?

There are 4 general methods of stock valuation namely:-

  • The Income Approach
  • The Earnings Approach
  • The Asset Approach
  • The Discounted Cash Flow Method

Meanwhile, I want to share with you something that I want you to give much thought to. Intelligent value focused investing is the work of a logical mind. However, a reasoning and logical mind will seldom alter an emotion. The only way to alter emotions (such as happy, greedy, sad, fearful) are with other emotions.

Learning the methods of stock valuation and discovering undervalued stocks is like finding gems in a treasure hunt. Believe me, intelligent value investing can be an extremely profitable endeavour – I know. Over time you will develop confidence and passion – two valuable emotions that will alter the base emotions of happiness, greed, sadness and fear, and that will lead you on to investment success.