Certainly Wrong

I recently challenged readers to test their future forecasting skills by telling me how much money General Electric (NYSE:GE) would earn in 2009. Specifically, I asked for those who knew for certain, to the penny, what GE would earn that year to tell me what that earnings number would be. I received a surprising number of responses to that request, yet no two were the same. That, of course means just one thing: I can guarantee that the vast majority of respondents who claimed to know GE's 2009 earnings with certainty are wrong.

So what?
Making investing decisions based on a false sense of security can be hazardous to your wealth. Let's consider the responses I received to my inquiry. The lowest projection for GE's 2009 earnings was $2.09, and the highest was $3.02. Trying to gauge GE's value based on either of those projected earnings levels results in the following:

Low valuation ($2.09 earnings in 2009)

High valuation ($3.02 earnings in 2009)

GE recently traded hands at $32.88, 18% above the low-end estimate and 31% below the high-end estimate. If my most pessimistic correspondent were to act based on his certainty, he'd probably be considering selling GE right now. On the flip side, if my most optimistic correspondent were to act on his certainty, he'd probably be buying all the GE he could afford. They can't both be right.

Wall Street reality check
Just as individual investors can be overly optimistic or pessimistic, so can the whole market. Even if you can never be certain of your own valuation, with time and practice, you can get a handle on what's reasonable. You can use that information as a sanity check against the market's ideas and only make investment moves when the market's valuations are way out of whack with what's realistically possible.

Take, for instance, pipeline companies. No matter what the market price of oil happens to be, the stuff has to travel as a raw material from the well or port to the refinery, and from there to the gas stations as a finished product. That's where the pipelines come in. Because oil must pass through a pipeline regardless of its market price, the pipeline companies are relatively resilient to the wild price swings that affect the price of oil. They act, in essence, like toll collectors who charge the same amount whether the car passing by is a Chevy Aveo or a Lamborghini Diablo.

Yet in the late 1990s, when oil was cheap, so were the pipeline firms. They were battered down by both the tech frenzy of the time and the low price of oil itself. Yet investors who understood the true nature of the business could have bought some excellent companies at significant discounts. As the Nasdaq high-tech bubble burst, more rational heads prevailed, and the same market that had been wildly pessimistic about the pipeline firms came to see their true value. This chart shows just how well investors who bought during the market's unwarranted pessimism were rewarded for their clear thinking:

On the flip side, we all know what happened to technology stocks at the turn of this century, right? The whole "New Economy" and how eyeballs mattered more than earnings, how rapid exponential growth could last forever, etc. . As much as we'd like to pretend it was all a bad dream, our pocketbooks and portfolios simply won't let us forget this reality:

There was a difference between investing where excessive pessimism had knocked the stuffing out of some stocks and where outrageous optimism had bid others to far beyond their worth. Those who recognized the excessive pessimism made money, while those who failed to notice the outrageous optimism lost theirs.

Investing in an uncertain world
The truth is that none of us knows for sure what will happen next. That's why the value investing strategy that we follow at Motley Fool Inside Value has worked for generations and continues to work today. Key to our approach is an acknowledgement that the future is fuzzy and that we can't know with certainty what'll happen next. That's why we build in something called a margin of safety with each of our stock picks.

In all honesty, the margin of safety is a little more than a fudge factor discount to our best estimate as to what a company is worth. If the company's market price is far enough below our discount, we buy. If it's not, then we pass. It's as simple as that. That way, even if our estimates were too optimistic, we still have a cushion to protect our invested cash. On the flip side, if our estimates were too pessimistic and the company consistently exceeds our expectations, we stand to receive a bonus return as the stock jumps to reflect the new projections.

Press your advantage
Because you can't tell the future, you can't know for certain what a company is worth. That's OK, because it means that neither can the market. You can get in the right ballpark, though, by focusing on a company's realistic earnings potential. By only buying when the market price is below that valuation by a comfortable margin of safety, you can help further improve your odds of investing success.

If you're ready to take advantage of the stock market's false sense of certainty, then join us at Inside Value. Want to see more? A 30-day free trial starts here.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric and of Kinder Morgan Management, a related company to Kinder Morgan. The Fool has a disclosure policy.