Understanding Stock Prices: Are You Paying for Hype or Value

Understand That Price Is Baked Into The Value

One of the biggest mistakes novice investors make is buying a stock simply because they like a product or service, or because a friend or colleague highly recommends it, or because it has dropped a lot and they think it must go up now. For example, someone might think, “I like coffee from Starbucks, so I’ll buy their stock,” or “All my friends use Facebook, so I’ll buy their stock.” Another example could be, “I found my spouse on match.comand she is so awesome, so let me invest in their stock,” or “President Trump tweets a lot, so Twitter stock must go up!”

The problem with this thinking is that you are just one person, maybe two if your friend recommended it to you. Do you know a company could have billions of outstanding shares and millions of people who have invested in that company at different price intervals? Do you know that thousands of people knew about this stock before you? Do you know thousands more have invested in these securities long before you had their product or used their services? Most of how great that stock is, is already baked into the price of that stock! Most of the time (not always), you are late to the game! Accept that a stock doesn’t have to do anything just because you now think it’s a great stock and have invested in it!

There are exceptions if you happen to know something that the average person doesn’t know (aside from insider information, which is illegal), but this is mostly not the case. For example, a startup company that you see growing locally with very little coverage, but they are expanding, or a certain industry is growing, and a particular company will grow with it. Keep in mind that most companies you find online, others have found before you, and the price is reflected in the stock. The price is baked into the stock because everyone wants to be the first one to invest in it. Investors start to predict and buy on rumors; everyone wants to get in before it’s too late! This is usually way before you realize it’s a great company and buy their stock.

Sometimes you are lucky enough to see what others don’t and get in early, but see how long a company has been around. A sports analogy would be like an athlete signing a contract based on his/her potential and not performance. LeBron James and Kobe Bryant signed deals for millions coming out of high school without ever playing a single game in the NBA! It was their potential, not how well they had played in the NBA. Similarly, investors react to rumors, so by the time the event happens, the stock price has already reacted to it and it doesn’t care that you have now entered the market. Actually, it never really cares when you enter the market—unless you are going to be buying in millions.

As you get better, you will be able to predict and buy stocks on potential or see their value before others, but for starters, stick to the actual numbers. Just understand that if you like a company’s product or their service, add it to your radar, but you will need to do more research before you buy by analyzing their numbers.