Where's the worst place to drive your car?
The wrong side of the highway is certainly a bad spot. But that's pretty easy to avoid. Down the white line is probably pretty bad, as is off a cliff. But we can certainly avoid those situations, too.
I would argue that another car's blind spot, while seemingly innocent, is one of the worst places to drive. There's added risk without any extra reward, eliminated by simply speeding up or slowing down.
Investing blind spots
Now think of the worst kinds of investments.
I imagine penny stock scams came to your mind. Maybe overpriced story stocks, the ones long on story and short on data, did too. It's true, those are bad. But I've got one that's far, far worse.
The loser is ...
The worst investment is the one that does not offer enough reward for the risk you are taking. Certainly penny stock scams and overpriced story stocks fit into that category. Believe it or not, even bargains can be dangerous investments. "Blasphemy," you say? Hear me out.
I believe stocks that trade for 75%-85% of estimated value are the blind spots of value investing. I know it doesn't quite make sense that a stock selling at a discount to its value is a dangerous investment. But I think those are the most seductive value traps out there.
Unless the bargain is really obvious, I think it's better to pass. Otherwise, I run the risk of pulling the wool over my own eyes in order to justify the decision.
Why they are evil
If you've done your homework and determined a stock is selling for 15%-25% below your estimate of its value, red lights should start flashing, warning bells should start ringing, and your online brokerage account should immediately lock up. That's because dangerous things can start happening when you don't demand enough margin of safety.
Trying to rationalize the bargain is common. I've said it many times myself: "This is a great company and it's not going to ever sell for 50%-60% of its value. I better get it here while I have the chance." Don't do it, folks. I beg you, don't do it. I was only fooling myself when I said this.
Another danger that rears its ugly head is overconfidence in our analytical abilities. Avoid this at all costs. That's because discounted cash flow analyses, while extremely useful and very important tools, are inherently inaccurate. The lack of precision when modeling uncertain future outcomes requires us to use a significant margin of safety to protect us from ourselves. Believing in our models too much can lead to buying at prices that don't necessarily reward us for the risks we are taking.
Finally, it's always tempting to say something like, "I bet the company can earn a bit more margin here or make another sale there." Those little tweaks that increase the value estimate can have big, unintended consequences if we're not careful. So if you must make them, remember that you must also assign a probability to the outcome to come up with an expected value.
"Street itself is boundary."
We have to draw the margin of safety line somewhere and then stick to it. Obviously, I think drawing it too close to the 75%-85% boundary is hazardous to your wealth. It reminds me of the Seinfeld episode where China Panda restaurant wouldn't deliver to Elaine's apartment. Elaine says the apartment is just over the boundary. The restaurant owner then asks: "If we deliver to you, then what? Eighty-fifth Street, Wall Street, Mexico, Eighty-fourth Street."
The moral of the story is: Create a margin of safety boundary and stick to it. Your portfolio will thank you for your discipline down the road.
Ones I recently missed
I don't make many purchases, but I always try to remember ones I missed. Home improvement retailer Lowe's
Some investment ideas that scare me
There are some popular stocks, however, that I won't touch. Wal-Mart
I've expressed my thoughts on Whole Foods
The Foolish bottom line
I think it's pretty easy to pass up stocks that are overvalued. And if it's based in Florida and trades on the American Stock Exchange, it's easy to avoid as well. It's those gray-area bargains that really cause problems.
The pressure to buy stocks with small margins of safety can easily get the best of us, but I never want to be in a position where I am simply fooling myself. So remember to draw your boundary and stick to it. That way you'll avoid those investing blind spots.
Retail editor and Inside Value team member David Meier is ranked 1,087 out of 27,827 CAPS members, and owns shares of Nike. He does not own shares in any of the other companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.