The biggest risk in investing is the price you pay for the particular stock you buy. There are also other risks, such as geopolitical conflict, supply shortages, interest rates, and so on. Different businesses will be affected by each of these factors in different ways. Some businesses are so great that even these risks at their worst doesn't hurt them. Even so, the price at which an investor buys could ultimately be their undoing. Let’s elaborate.
Give a man a fish, and you feed him for a day.
Teach a man to fish, and you feed him for life.
The proverb above is usually attributed to Confucius, the ancient Chinese philosopher. Assuming he did say it, it’s a very wise observation, but he could have gone a little farther:
Give a man a fish, and you feed him for a day.
Teach a man to fish, and you feed him for life.
Buy the man out, and you feed yourself for life.
A man who learns how to fish can now produce earnings. He is basically a sole proprietorship for fishing. You could buy him out and thus be entitled to all the fish he acquires. If you did that, you would pay him based on how much fish you think he can actually produce.
Now imagine that you teach five men to fish. You teach them all the same way and they use the same fishing rods. Even if they all fish in the same body of water, would you considering buying them each out at the same price? What if they are not the same age? What if some work harder than others? What if some are more honest? What if some are clumsier than others? Even with an equal start, buying them all out for the same price is likely not a wise move considering some will produce less fish for you.
Even the best of the five has a price that is too high. If he kept haggling you up, eventually you would reach a point where his earnings are not enough to make it worthwhile. Even if he can catch 20 fish a day, while the others can only catch 5, then it wouldn’t make sense to buy him out for ten times as much as the others.
Why paying a higher stock price is risky
A higher stock price increases the risk that you will lose money or get a weak return. A lower price decreases the risk that you will lose money. It’s common sense. Buying him out at $100,000 is inherently riskier than buying him out for $50,000. Higher risk does not lead to higher reward; it leads to lower reward by mathematical necessity.
This is why giving a man a fish is on the lowest order of the proverb. Its value is very episodic. A single fish isn’t going to produce earnings, but the fisherman will. Confucius realized that there is more value in creating fishermen than in handing out fish because of the rise in earnings. Flipping that, the investor should conclude that there is more risk if the earnings are smaller and if the price is too high for the earnings.
This is easy when comparing a fisherman to a single fish (whose earnings are zero). The best investors know how to compare individual fishermen. Even if all the fishermen are excellent, the investor will be subject to greater risk if he overpays for them.
The credit for this content goes to Joe Parish. If you have enjoyed it be sure to check out his other articles on this link.
How do you avoid overpaying for a stock?
Avoiding overpaying for a particular stock and thus investing in undervalued stocks is both an art and a science. There are countless ways to go about this, some of which are more and less effective than others. However, there are timeless principles that you can apply to aid your analysis. If you are interested in these check out our guide on how to find undervalued stocks.
We wish you all the best in your investment journey!
The Wisesheets Team
