Over the last several weeks, I’ve been speaking to a number of personal friends about the state of the financial markets right now. Basically, we all feel like most major assets seem overpriced at the moment. Or at the very least, they represent more risk than reward.
Now, the people I’m talking about include the portfolio manager of a very large institutional real estate fund … who is selling far more properties than he is buying. Plus, an executive at a major Silicon Valley tech firm … who feels like valuations in his industry also make no sense at this point.
So are we crazy? Or is it everyone else?
Well, there’s no way to know until it’s too late. But at the end of the day, rather than succumb to emotions or "feelings" about our investments, all we can do is rely on the numbers to keep us in check.
For example, it’s far cheaper for me to rent rather than buy a comparable house in my neighborhood. So that’s what I’m doing.
Likewise, with price-to-earnings ratios on stocks looking stretched, I’m only looking to buy companies that represent true value.
Of course, the reality is that — even if investors try to use numbers to make their decisions — they often fail to understand some of the measures anyway.
Here are five of the most egregious examples I’ve seen over the years …
#1. ‘Cheap’ Stocks vs. ‘Expensive’ Stocks
Everybody loves "cheap" stocks. Unfortunately, this label means different things to different people.
To a lot of investors, a cheap stock is merely one that costs a small amount of money per share — maybe a penny stock or one under $10.
They view this as a positive because they can buy lots of shares.
But the reality is that there is no inherent advantage to owning 1,000 shares of a $1 stock, vs. 10 shares of a $100 stock.
While you might see more relative volatility from lower-priced stocks, it doesn’t necessarily make them better investments.
You’re far better off looking for stocks that are "cheap" based on business fundamentals — earnings, cash flows, book value, etc. — no matter what their nominal price.
Speaking of which …
#2. Dollars vs. Percentages
I frequently have people tell me how many dollars a particular stock gained or dropped. But they don’t realize that it doesn’t really say very much by itself.
After all, a 10-point drop on a $20 stock is the same thing as a 50-point drop on a $100 stock.
So, I would much rather focus only on PERCENTAGE profits and losses. They have all the important things — like the starting price or total investment — baked right in.
Likewise, always look at different positions you might own as percentages of your total stock portfolio … and your total stock holdings as a percentage of your overall investable net worth.
Thinking in percentage terms helps put everything you’re doing into the right context.
Of course, even people who already use percentages frequently make the following mistake …
#3. Percentage Gains vs. Losses
Pop quiz: If your stock rises 50% and then quickly falls 50%, is it back to the price you paid?
On the surface, the answer seems to be "yes."
But let’s look at an example:
Jane buys one share of XYZ at $100.
It rises 50% to $150 (0.5 X $100 = $50).
Then it drops 50% (0.5 X $150 = $75).
So, Jane actually has just $75 to show for her original $100 investment after that percentage roundtrip!
#4. Dividend Yields
Since I specialize in income investments, I field a lot of questions about calculating yields.
When it comes to stocks, the simple answer is that you take the annual indicated dividend amount and divide it by the stock price.
So, a $10 stock that will pay out a $1 in dividends over the next year has a 10% annual indicated yield ($1/$10 = 0.1 or 10%).
However, remember that once you own a particular investment, it’s far more important to track YOUR yield on cost rather than the number you might find on a website.
This is because, once you buy a stock (or other income investment), your cost doesn’t change.
At the same time, the dividends CAN change — either up or down.
So, if a company keeps raising its payments, your annual yields keep going up, too!
That brings me to one last thing to keep in mind …
#5. Stock Splits
A lot of investors misunderstand stock splits — in my opinion, they are neither inherently good nor bad. Companies simply do them to make their share prices seem more "affordable."
In other words, they are staying mindful of the very first point I made above — which is the fact that most investors feel better buying more shares of a lower-priced stock than fewer shares of a higher-priced stock.
Again, the reality is that a given investment amount is still buying you the exact same stake in the company whether it splits or not!
The reason is simple: All the stock’s attributes simply get divided by the split factor — whether you’re talking about per-share earnings, dividends or some other number.
The bottom line is that using numbers is the only way to minimize the various emotions we all experience as we go through various market cycles. However, the numbers themselves are also only as good as they way you’re using them.