Investing on your own? Here are three principles to live by

2. Price does not equal value

Extending the bakery analogy, imagine that your brother-in-law came to you every morning with an offer: a price he would be willing to pay for your share of the business, and a price at which he would be willing to sell you his. This is exactly how the stock market works - you own a slice of a real business and get a constant stream of offers from other shareholders. 

The intrinsic value of a business is a function of all the cash it will receive, discounted back into today's dollars at a suitable rate of return. The market tells you the current price people are offering to buy and sell it. There's a big difference. I can offer to sell you a $10 note for $15, but that doesn't mean the note is worth more. Share prices bounce around far more than the value of the underlying businesses because share prices are dictated, at least in the short term, by human psychology.

If you're focused on the share price, rather than the business, you're going to make silly decisions. You wouldn't do this for your bakery: you'd care about how the bakery was doing at the end of each year - how much money it made, whether a new bakery opened next door, whether it needed to borrow cash etc - than what offer price your nutty brother-in-law comes up with.

Volatile share prices are a source of opportunity: If you have a firm idea of what your bakery is worth, when the offer price undervalues it, you can increase your ownership stake, and when it's too high, you can sell. A volatile share market gives you options, nothing more. You never have to act. Benjamin Graham first explained the idea that a wild stock market was advantageous to level-headed investors in his book The Intelligent Investor. He also developed this next philosophy. 

3. Build in a margin of safety

No one knows what that future will look like. You can make some educated guesses based on a company's history, its competitive advantages, and forecasts about market growth and profitability. But ultimately you need to leave room for errors in your forecasts. If you do the sums and figure a company is worth $5.00 per share, that doesn’t mean you should buy aggressively when the share price hits $4.99. It might be better to wait for a wider discrepancy of 20-50% so that if something goes wrong, you aren't caught overpaying. A margin of safety won't eliminate mistakes, but it will swing the odds in your favour.  

Graham Witcomb is a senior analyst at InvestSMART (under AFSL 282288). This article contains general investment advice only. It has been prepared without having regarded to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of CommSec. The article was originally published on 26 November 2018.

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