Economy, how do you frighten me? Let me count the ways:
- The yield curve is bordering on inverted, which often foreshadows a recession or even a depression.
- There might be a housing bubble (or there might not be, or there might be), and rising interest rates are finally starting to hit that market. Consumer spending has been driven by people cashing in on the cheap equity in their homes. Who knows what will happen if housing prices fall -- reducing homeowners' equity and their ability to use that equity to buy new gadgets from, say, China?
- Consumer debt ratios are already at all-time highs.
- And then there's the dollar. We're running record budget deficits and record trade deficits -- meaning that other countries are lending us money so that we may sustain our lifestyle. If they pull the plug on us, we could face a plummeting dollar -- likely resulting in inflation, stock market troubles, and a real decline in both wealth and income. (Wow, I haven't even mentioned war, terrorism, hurricanes, rogue waves, oil, derivatives, secular bear markets, or Sith Lords.)
Luckily, what's bad for the economy isn't necessarily bad for investors.
Pulling the wool
The media focus 90% of their attention on these issues because the stories are exciting. But when it comes to investing, these matters don't even account for 10% of the big picture. Ours is arguably the most resilient country on the planet. Last century, we faced World Wars I and II, the Cold War, the Great Depression, the failure of numerous banks, the impeachment of one president, the resignation of another, an oil shock, interest rates rising from 2% to 15%, several stock market crashes, and, of course, disco. We didn't just survive -- we overcame these challenges and prospered (and danced).
These macroeconomic issues are scary. But instead of being overwhelmed by the impossibly complex whole shebang, narrow your focus to individual companies. The market doesn't dictate your portfolio's performance; that's dictated by the performance of the stocks you own. Even in a bear market, some stocks outperform. Your job is to find those stocks and snatch them up.
Don't be fooled: There will be risks -- but don't let them keep you up at night. That's not to say that you shouldn't be aware of risks, but rather that you should focus your analysis on understanding how such factors can affect the businesses in your portfolio. If you own Pfizer or Merck, for example, war and hurricanes will likely be less important to you than legal issues. These two companies' businesses depend on their ability to both defend their patents in court and manage their liability when they make mistakes. If you're going to invest in either firm, you should focus some effort on understanding legal risks.
Beyond these macroeconomic factors lurk two potential mistakes. The bad news is that they can destroy your returns. The good news is that they're completely under your control.
1. Not knowing what you own: The biggest mistake you can make in the stock market is not understanding what you're buying, or what you already own. While the market may seem irrational, over the long term it's supremely logical. Strong companies prosper, while weaker companies die or are devoured by competitors.
So before you invest, make sure you have rational reasons for investing. Don't invest based on tips or stories; only invest in businesses. Make sure you understand how the business makes money and why it will continue to do so in the future. If you don't understand float or a combined ratio, don't invest in Chubb
At Motley Fool Inside Value, to get up to speed on a company, we begin by picking through its SEC filings, such as its 10-K. These documents provide an overview of what the company does and its potential risks. Then we sift through articles, conference calls, websites, press releases, and even discussion boards. Finally, we distill that knowledge into a summary to understand a company's business, competitive position, and risks.
2. Buying above fair value: A second mistake that should frighten your boots off is the possibility of buying stocks above their fair value. Look at the long-term charts for Hewlett-Packard
The problem? They bought these stocks at prices way above their fair value. Regardless of how successful you are at picking "the next big thing," if you consistently buy businesses well above their fair value, you'll underperform. It's simple mathematics -- if you pay $1 for something worth $0.50, you're almost certain to lose money, unless you can find a bigger idiot willing to pay even more than you.
This dynamic is reversed when you buy below fair value. If you pay $0.50 for something worth $1, you have a decent chance of later being able to sell at a profit, and less chance of losing money. That's what value investing is all about.
Knowledge is power
The way to deal with potentially terrifying issues is to be in the know -- know the business in which you're investing, and know its fair value. Such knowledge not only reduces macroeconomic nightmares to manageable risks, but it also puts you in a profitable position when fears of such risks are overblown.
If you want to get ahead of the pack, Inside Value can help. Our analysis of undervalued stocks will give you a head start in identifying undervalued companies. A 30-day free trial will give you access to all Inside Value content: our top recommendations, our discounted cash flow calculator, five special reports, and our discussion boards. It's free with no obligation -- just click here to give it a try. Don't be scared.
This article was originally published on Jan. 3, 2006. It has been updated.
Fool contributor Richard Gibbons is a member of the Inside Value team, a father, a husband, a chess player, a juggler, and a geek. Richard has no financial position in any company discussed in this article. Pfizer and Dell are Inside Value recommendations. Dell is also a Motley Fool Stock Advisor choice. The Motley Fool has a disclosure policy.