When evaluating investments, look at value
Published 2:28 pm Friday, January 15, 2010
Most investors pay a great deal of attention to the price of their investments—yesterday’s price, today’s price, tomorrow’s price, next year’s price and so on.
And that’s understandable, because we almost always want the prices of our investments to rise.
Yet if you focus too much on price, you could end up making some costly mistakes.
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Because price-driven behavior is emotional behavior—and as an investor, you’re much better off making decisions with your head, not your heart.
Suppose, for example, you’ve seen a steep decline in the price of one of your investments. After awhile, you may believe you just can’t take it anymore, and you decide to “cut your losses” by selling the investment.
Conversely, you may have an investment that has gone up and up—and you decide to try to grab even bigger gains by buying more shares.
Both these decisions could backfire on you. When you sell an investment whose price has fallen, you might find yourself on the investing “sidelines” if that same investment starts to turn around. And when you throw more money at an investment whose price has skyrocketed, you’re betting against history—because no investment goes up forever.
Furthermore, in both cases, your emotions will have led you to violate one of the guidelines of investing: Buy low and sell high.
But apart from the tactical errors you may make when you devote so much attention to price movements, your over-concentration on price may lead you to ignore another key characteristic of investments: their value.
Traditionally, an investment’s “value” has been largely defined as whether it’s considered “expensive” or “cheap.”
That’s why many investors take a close look at a stock’s price-to-earnings ratio (P/E). You can calculate a stock’s P/E by dividing its price by its earnings per share.
Generally speaking, a stock with a high P/E is more expensive, relative to its earnings, than a stock with a low P/E.
Investors may be willing to pay more for the high P/E stocks because they believe these companies will be worth more in the future. However, P/E doesn’t tell the whole story of investment value.
You will find that any individual investment can have value to you because it can help you diversify your holdings. And while diversification, by itself, can’t guarantee a profit or protect against a loss, it can help you reduce the effects of volatility on your portfolio.
For instance, if your portfolio is heavy with stocks, the presence of some bonds—even those whose market price has fallen because interest rates have risen—can help reduce the impact of a downturn that primarily affects stocks.
Clearly, the value of any investment has different dimensions—any or all of which may be valuable to you as you pursue your goals.
So, as you build, maintain and adjust your portfolio over time, keep an eye on the changing prices of your investments—but don’t overlook their true value.