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Investor Toolkit: When useful investment terms lead to costly mistakes

Stock Investing

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment tips and stock market advice. Each Investor Toolkit update gives you a fundamental piece of investment advice, and shows you how you can put it into practice right away.

Today’s tip: “Investor shorthand can provide a useful guide to investment information, but it can also oversimplify analysis and events and steer investors into bad decisions.”

Investor shorthand can help you think about and talk about large blocks of investment information. But it may also lead you to make associations and come to conclusions that can cost you money.

For example, think about the common investor shorthand term, low-p/e stocks. It encompasses four statistics: price per share; per-share earnings; the p/e (the ratio of a stock’s price to its per-share earnings); and low p/e (which suggests a normal range exists for p/e’s generally, or for p/e’s of stocks of a particular type or description, and that these stocks are near the lower half of the range).

Some investors, beginners especially, see special appeal in stocks with low p/e’s. They jump to the conclusion that the p/e is low because the “p” or stock is low, and that this is a sure sign of a bargain. When you use that term to generalize, however, you can lose sight of the fact that p/e’s can be (or can seem) low for all sorts of reasons.

For example, maybe the “e” or earnings is temporarily high, due to unusual factors that will soon revert to normal or worse. Or, the stock price may be low, and headed lower, due to negative conditions or trends in the company or its industry.

Of course, many experienced investors understand how the use of shorthand investment terms can warp investor perceptions, and lead them to take on unwanted risk. But they fail to see the upside-down version of that risk in newer, poorly-defined terms. One good example is “bubble”.

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The long bubble of the automobile industry

When you label a particular investment area as a “bubble”, you are saying that it’s so over-priced, and has generated such high investor expectations, that current buyers are bound to lose money. That situation does occur from time to time. However, cautious observers tend to throw the term around way too widely, and way too soon. It’s as if they want to warn others against investing in any area where prices are rising.

Before you dismiss a promising investment area as a bubble, try to remember that bubbles and bull markets last much longer than pessimists predict. The U.S. auto industry went in and out of a bubble from its beginnings in the early 20th century until its yearly production finally hit a lasting peak in the 1970s. Netscape (owner of the first widely used Internet browser software) doubled overnight after going public in 1996, and some took that as a sign that the Internet boom had peaked. That same year, Federal Reserve Board Chairman Alan Greenspan made his famous comment about irrational exuberance in the stock market, but the market kept on rising for four more years.

The Standard & Poor’s 500 market index has tripled since 1996. The Internet boom is still underway, although it goes through wide fluctuations from year to year, just like the auto industry of the previous century.

Investor shorthand can help you classify investment information. But if you let it take the place of analysis in your thinking, it can lead you to invest in low-p/e stocks that are about to demonstrate why they were trading at a seemingly bargain price. It can also lead you to miss out in opportunities that looked like bubbles early on, but turned out to be decades-long booms.


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