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Topic: How To Invest

Investment thoughts 101: Why snap judgments could ruin your portfolio

Here are some investment thoughts on snap judgments, the investors who make them and how they can hurt your portfolio.

Snap judgments can be a great time-saver, but they’re a poor tool for investment decision-making. Investment thoughts involving snap judgments often produce extreme, random results—good or bad. If you happen to make money with a series of snap judgments, it can turn into a habit. This may lead you to invest ever-larger sums of money this way, and that’s when your risk really rises.

After all, your random results will turn eventually from good to bad. That’s liable to happen just when random bad results can do the most damage to your finances.


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The biggest problem with snap judgments: They’re based on short-sighted investment thoughts

The problem with snap judgments is that they deprive you of perspective. It’s better to base buy and sell decisions on a broad sample of the vast information that’s available on any investment. With snap judgments, you zero in on a tiny and unrepresentative sample such as an individual news item.

This news item may be an earnings report that beats the consensus forecast (the average earnings estimate from brokerage analysts). You may see this so-called “positive earnings surprise” as a sign that points to a lasting rise in earnings and the stock price—one that can go on for weeks, months, even years.

Of course, the stock’s rise may instead last for hours, minutes, or seconds—if it happens at all.

The funny thing is that earnings estimates are based on info supplied by the company. Some companies routinely try to manage brokerage-analyst expectations “downward.” That way analysts routinely underestimate their earnings. This can lead to a string of “positive earnings surprises”—earnings reports that beat the consensus.

This may give some investors the idea that the company is forging ahead much faster than expected.

In that case, the market may reward the company with a higher per-share price-to-earnings (P/E) ratio. It may trade for 22.0 times earnings instead of, say, 19.0 times. This can cut the company’s cost of financing. It can also make it cheaper to provide stock options to executives. But the fun can end abruptly.

For instance, suppose the company runs into unforeseeable earnings problems. This may lead to a “negative earnings surprise.” Earnings may come in far below the consensus, perhaps lower than recent quarters, and may even show a loss. This can spur selling by a lot of “snap-decision investors.”

Investment thoughts: Keep in mind that one-time gains can artificially inflate a company’s earnings and lower its P/E

Make sure you factor out low P/E’s that arise if a company records a large one-time gain, such as when it sells assets. One-time gains temporarily balloon earnings and shrink the P/E ratio, and are not representative of the company’s true ongoing earnings. Similarly, you should add back any one-time write-offs, so you don’t miss any stocks that have low P/E on an ongoing basis.

Final investment thoughts: snap judgments and the investors who make them

We’re focusing here on earnings reports as an example of a snap judgment because they can spur conservative investors to buy or sell. More aggressive investors may buy on much flimsier news items such as the launch of a new product line, the possibility of a big contract from a major (even unnamed) company, rumours of a takeover bid—anything can do it.

You can get lucky with snap judgments, just as you can with lotteries. But if you let snap-judgment investing become a habit, it will eventually cost you money. The flimsier the basis for your judgments, the more you’re likely to lose.

Better investment thoughts: Maintain a healthy sense of skepticism

If an investment sounds too good to be true, it probably isn’t true. Recognize, too, that some of your most promising investments will disappoint you, since no one can predict the future.

Remember, the investment business deals in intangibles and relies on trust, so it attracts more than its share of crackpots, dreamers and crooks. They have an uncanny ability to home in on trusting investors who accept dubious claims at face value. But if you follow a stock market investing strategy of diversifying and focusing your investments on well-established companies, your gains will offset your losses.

Have you made snap judgments in investing? What was the result?

While snap judgments may not be a good strategy in the long term, is there a snap judgment you’re sorry you didn’t follow through on?

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