Having Confidence in Your Investment Selections

by JT McGee

Actively-managing your money requires confidence in your investments.

I don’t care if you invest in real estate, stocks, bonds, or canned goods – you have to be confident enough to pull the trigger.

How to Develop Confidence in Your Portfolio

Like all positive attributes, confidence is something that can be learned. It’s something that you can create.

The first step is to…be less confident: admit what you do not know. You probably know a whole lot about a billion different things. You’re confident in your knowledge. But no matter how confident you are in that knowledge, I bet you’re even more confident about what you do not know.

Name a topic, and I can tell you what I know about it. Most things are going to get a pass. And that’s okay because…

Focusing on What is Knowable is Key

Some things just are not knowable. And that’s totally cool. So when we look at an investment, it isn’t about knowing absolutely everything about that investment. Because we cannot know everything about anything. We’re only human.

So let’s talk about how to logically be more confident in an investment. How can you hold a stock or house, or whatever and have the confidence to know it’ll work out as an investment? You price in your stupidity!

See – here’s the deal, wealth is about screwing up least. No joke.

So let’s say you and I sit down and run a discounted cash flow analysis on some stock. We arrive at a value of $10. You say you need a 10% margin of safety, and will only buy the company at $9 per share. I say I need a 30% margin of safety, and will only buy the company at a price of $7 per share.

Now, the market goes up and down. Stuff happens. The stock gyrates. You buy in at $9. I purchase shares at $7.

Now, who is going to be more confident that they’ll be making money? Me. I bought at a lower price. And sure, I might have to listen to you tell me how I missed a once in a lifetime opportunity. I might have to deal with the reality that the stock goes to $10 from $9. I might miss out on that 11% return. I might miss out once, maybe twice. Maybe three times I’ll miss 11% returns.

But I never had to sweat it. I never had to worry that I could buy something at $9 and sell it for $10. That would stress me out. I have ZERO margin of safety in our analysis at that price. None. A minor deviance from our analysis about the future of the company would crush my shot at making a profit.

It may take 3 years to realize that 10% margin. A lot can happen in 3 years. Many of these happenings can blow my analysis out of the water. So I need more protection to compensate me for the risk.

Be the Pawn Stars

The Pawn Stars are a great example in the value of a margin of safety. Superb, really. They never buy anything unless they’re certain they can at least get their money back out of something.

That’s why pawn shops do as well as they do. Pawnbrokers only know so much about something. But because they price in what they do not know when they buy something, they know that they will, in the long run, make money on their purchases.

Pricing in what you do not know with a larger margin of safety allows for you to have confidence in your investment selection. I like to have a huge margin of safety. A massive margin of safety is key. I want to buy what I see to be $10 bills for $7. I can sleep well at night doing that. I cannot sleep well at night buying the chance at $10 for $9.

That’s risky.

I like to relate it to retail. See, Walmart can pay $3 for paper towels it sells for $3.29. It can afford to do that – the market is there. Prices are mostly fixed. It knows the demand is there.

The stock market is not like that. The used stuff market – the market in which pawn shops operate – is not like that. So you have to have a big margin of safety. Pawn shops would go broke buying $3.29 items for $3. There’s no way to know that item will sell in a week in a pawn shop. Walmart knows it will sell its $3 inventory for $3.29 in the next seven days. There is really no question about it. No big margin of safety is really necessary.

Confidence Comes from Not Caring

Sam at Financial Samurai likes to give me a hard time about the valuation I place on individual stocks. That’s cool. I have no problem with it. If Facebook goes to $50 per share tomorrow, I expect a tweet from him telling me how I missed it.

Thing is, based on my margin of safety requirements, I could never own Facebook at $27 per share. I could never own it at $20 per share. And other people may make plenty of money buying the company at $27 per share and selling it back to the market for $34.

That’s okay. But that’s just not my game. I don’t trade. I don’t speculate. I invest.

There’s a very big difference between our two views on the markets. I look to buy businesses; he looks to buy appreciating ticker symbols.

Facebook as a business is not worth $27 per share to me. Facebook as a speculative position was apparently worth $27 to him. And speculative it must be, since I get the feeling Sam hasn’t looked at the financials. You can make money doing that. Many people do.

But to me, that’s risky. That doesn’t make sense to me. That does not give me a margin of safety. If Facebook is worth…say, $10 per share based on my margin of safety requirements, why would I pay $27 for it thinking I’ll be able to sell it for $34? That doesn’t make sense to me.

I don’t want to sell to people I deem irrational – that means my analysis is irrational.

Errors of Omission are better than Errors of Commission

Leaving a stock out of your portfolio because you are not comfortable with the margin of safety is better than bending the rules to buy the stock.

Missing out on something is better than getting into something that causes trouble. Stringent Pawn Stars-style investing will mean that you miss out on some good opportunities. But it also means that you avoid big losers. I would much prefer to have a high accuracy rate than a low accuracy rate. I’m comfortable with getting fewer things right.

I’d rather get 9/10 things right than get 10/20 right, even if those lower accuracy wagers pay better. It’s about comfort. It’s about confidence.

In short, enforcing a stringent rule for a massive margin of safety does make investing harder. It means you have to work more. It means you have to do more digging to find good investments. It means that where others might like 1500 out of 8000 listed tickers, you might only like 100. And you might only buy 10. But that’s okay.

In short, having confidence comes from pricing out your weaknesses. It comes from making errors of omission – you’ll miss out on plenty of winners when you require a larger margin of safety. But you’ll avoid errors of commission, too. And there are many more crappy stocks out there than amazing stocks.

{ 3 comments… read them below or add one }

Robert @ The College Investor July 9, 2012 at 19:33

Great points on safety margins! I’m a value investor by heart – and I like to buy companies that are not just undervalued, but undervalued to the point I feel comfortable as well.

Reply

PK July 10, 2012 at 10:09

I heard someone talking about how the stock market it like a bus (on your last point). If busses keep stopping, you don’t need to get on any individual bus, you can just wait for another one. I like to look at it like that, for what it’s worth.

Oh, and my confidence is limited to 20% of my net worth still, haha.

Reply

American Debt Project July 13, 2012 at 16:59

This is excellent. It is great to read other people’s investing philosophies and your logical thinking appeals to me. Even though you are investing businesses, you still always have an exit point/strategy, I assume? I want to read more about your process. I only own two individual stocks and they have performed very well for me. But I have no exit strategy and that makes me nervous. Graham’s Intelligent Investor is next on my list of financial books to read.

Reply

Leave a Comment

*

Previous post:

Next post: