Are You Making This Obvious Investment Mistake?

One of the most difficult aspects of investing is deciding how much to pay for a stock. Clearly, a lower …

a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

One of the most difficult aspects of investing is deciding how much to pay for a stock. Clearly, a lower price is always better than a higher price as it means there is a wider margin of safety and higher potential returns.

However, sometimes it may not be possible to buy a company's shares at a rock-bottom price. For example, the company in question may be performing well and its valuation may never drop into 'good value' territory. In such a scenario, an investor may decide to avoid the stock and miss out on strong investment performance in future. This could prove to be a mistake that is repeated and which has a considerable opportunity cost in the long run.

Focusing on quality

Perhaps the best-known proponent of value investing is Warren Buffett. He has recorded exceptional gains on his portfolio over a long period to become one of the richest people on earth. However, even he has stated that he would rather buy a great company at a fair price, rather than a fair company at a great price. In other words, his main focus seems to be on the quality of a company in terms of its financial strength, competitive advantage and future growth prospects, rather than its valuation.

This is a logical stance for investors to take. The stock market tends to reward companies that are able to grow earnings at a rapid rate on a consistent basis with a higher share price. It rarely rewards stocks which offer average earnings growth or relatively downbeat earnings outlooks with a higher valuation. Therefore, it makes sense to focus on the stocks which have the potential to beat their peers when it comes to growth, rather than on the companies which are cheap at a particular time.

Focusing on value

Of course, this does not mean that a company's value should be ignored. Paying an extortionate price for any stock is rarely a sound move – no matter how strong its future prospects are. However, it may be prudent to take into account a company's quality, historic valuation and the prices of its sector peers when determining what it could be worth. This may help an investor to justify a higher entry point for a stock, and avoid the mistake of missing out on companies with the most attractive long-term growth stories.

Clearly, paying more for any stock means there is a narrower margin of safety on offer. This could lead to greater losses than if a lower stock price had been demanded by an investor before purchase. However, the reality is that buying companies which have better balance sheets, faster-growing profits and a larger competitive advantage generally means less risk than stocks which are struggling financially and operationally.

As such, following Warren Buffett and seeking the best stocks at fair prices could be a worthwhile endeavour. It may mean investors avoid the mistake of missing out on the best investment opportunities due to an over-reliance on valuations.

Motley Fool contributor Motley Fool Staff has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

More on ⏸️ Investing

A white and black robot in the form of a human being stands in front of a green graphic holding a laptop and discussing robotics and automation ASX shares
Technology Shares

Joining the revolution: How I'd invest in ASX AI shares right now

Advances in artificial intelligence (AI) could usher in a new industrial revolution. Here’s how you can invest in it.

Read more »

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »