Recently we’ve been doing a series on the effects our emotions and thought-processes have on investing. In our first article we discussed how the majority of financial theory is predicated on the belief that people make rational decisions, but that in reality, this is rarely the case. One of the most common instances where we see this play out is when investors fail to distinguish the difference between a great product and a great investment. On more than one occasion I’ve heard someone say something to the extent of “I bought their stock because I really love the merchandise they churn out.” Unfortunately, this is a prime example of irrational thinking. Just because someone drives a nice car doesn’t make him a good mechanic. In fact, if you really want to find out whether he’s a good mechanic, you need to take a look under the hood and find out how well he’s truly taking care of things.
I once heard of an advisor who would ask his clients what companies they liked and then buy those companies in their portfolio. If this ever happens to you it should immediately raise some major red flags. Just because you like your smartphone, laptop, running shoes, car, or local superstore doesn’t mean that the company behind it is a good investment. In fact, you really have no way of knowing whether or not an investment is good or bad until you pop the hood – and open up the books. You may really enjoy a company’s product, but it may turn out that the product is really expensive to make and the company’s profit margins are actually really slim, making it hard for them to grow. Or you may discover that the company is undergoing a restructuring or has recently endured heavy litigation costs, which may impact whether or not it’s a good buy. Ultimately, it’s important to understand not only the state of the company behind the product but also its value relative to the price it’s trading at. Your preferred company may turn out to be in really great shape, but because that knowledge is well known, the price has been bid up, making it an expensive buy and a poor investment.
Whenever you consider any type of investment, it’s important to question what attachments you may have with it. Ask yourself why this investment is a good investment? If the answer is that you like the product or service, it’s probably a good idea to dig deeper and learn more about the company before jumping in. Furthermore, just because you may like a company and think it is a good buy, doesn’t mean that it fits well with the portfolio you already have. In fact, portfolios that are built in a piece-meal fashion often end up with a rumble jumble of varied holdings that work against each other instead of in harmony and lead to sub-optimal performance. If you’d like to learn more about the benefits of diversification and how to invest for success, check out some of our other articles or give one of our advisors a call today.