The approach works because human beings just aren't very good at it, but that is also what makes it hard.
To be successful, you need to do two things:
- first, you need to control your emotions so you can make objective decisions; and
- second, you need to be able to pick out a few undervalued stocks.
How to pick out a few undervalued stocks?
This is an inexact science at best of times, and utterly impossible at others.
There is no such thing as an exact valuation for a stock. Getting to grips with this inexactness is absolutely critical to investing success. Most importantly, it means that when you do invest in a stock, you'll want a large margin of safety so you can be wrong about a few things and unlucky about some others and still come out okay.
Large margins of safety are rare, so you need to be very fussy about your selections. You might find just one or two really good opportunities a year, but you.ll need to work hard to find even them, scanning the business pages, reading publications and doing your own research. When you find them, however, they should scream value to you almost any way you look at them.
So you need some quick and easy valuation tools by which to filter opportunities, to see if they're worthy of more research. By focusing on fewer really interesting opportunities, you'll spend more time thinking about their long-term business advantages and disadvantages, which are what will really make the difference to a stock's value.
First, we need to ask ourselves a more basic question: what exactly is value, anyway?
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