ASX shares can be a great tool to build wealth, but it's important not to get wrapped up in a particular stock or sector.
Some investments have demonstrated a long-term track record of compounding growth, without the large swings of booms and busts.
However, we've also seen some big bubbles burst. It's a good idea to avoid those alluring investments which could be a trap, particularly if looking we're at them after there has already been a huge jump in their share prices.
The danger of loving a volatile investment
Henry Jennings from Marcus Today was recently quoted in The Age, explaining why it can be dangerous:
Because love is blind, you need to make sure that you have fallen for the right one. You need to check that you are not blindly following a sector or trend.
Hot sectors attract less than scrupulous companies who are more interested in a pump and dump and raising money to pay directors. There will be many pretenders. Only a few winners.
Don't get sucked into the next big thing. Do lots of research and continually question whether the project stands up.
Everyone loves a good story. The idea that an ASX small-cap share can generate large returns is really appealing, particularly if it has plans on how to do it. A business that is developing a new healthcare treatment or looking for a new mineral deposit could do extraordinarily well if it's successful.
But those speculative ideas sometimes don't play out as positively as the company would hope, to the detriment of the investors backing the business. That's why those types of ideas are seen as high risk and why there's more potential for capital losses.
I'll also point out the danger of the market getting too far ahead of itself with an ASX share (or sector), even if it's not a risky biotech share or a resource explorer.
The valuation needs to make sense
When we invest in ASX shares, we're not just buying ticker codes – there are real businesses involved.
I don't think there's much point investing in a company that's seemingly never going to make a profit. After all, making a profit is the main point of being in business.
Businesses are only going to be able to make a certain amount of profit in the future (not infinity). Some analysts like to do a discounted cash flow analysis to try to work out how much the business should be worth.
That profit is going to be worth a certain amount to the market at the time, whether that's three years down the line, five years, or any particular timeframe.
Does today's price actually make sense for how much profit may be made in three years? Is there a fair chance the profit may not be as large or as certain as the market is pricing it? The market already knows about the 'optimistic' case for the business, such as growing lithium demand or a store rollout plan. But is today's price actually undervaluing the opportunity?
Sometimes investors get way too ahead of themselves, sending a share price up a huge amount when it's based on a temporary factor. An example is when a cyclical commodity price is at the top of its cycle.
Time and again, I've seen investors price a cyclical ASX share as though the conditions are seemingly permanent. It pays to remember a strong commodity price may not last forever. However, weak conditions may not last forever either.
It could be a mistake to price a business as though the commodity price will stay low. Personally, this is when I like to pounce on opportunities. Retail is another sector that can see changing conditions and investor confidence.
Foolish takeaway
It's a good idea to do research about the positive potential of an investment. But don't get wrapped up in the story without taking into account the price and what the market is implying with a company's market capitalisation.
If we overpay for a business that's overshot a 'fair price' then, at some point, there could be a danger of a sizeable share price decline. So the bigger the safety margin we buy with, the better.
Some people end up selling out of their investments when their investments go down, locking in a loss. It goes without saying that buying high and selling low is not a strategy we should follow.
