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Socks, Stocks and Value from Warren Buffett

Finance

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Getting fair value

Today’s quote comes to us from one of the greatest investors of all-time, Warren Buffett. Part of his genius is the ability to put ideas into simple, understandable terms. Everyone likes to get good value for their money. The hard part is in figuring out what a good value is.

When it comes to the things we buy every day, most of us have a pretty good sense of what a fair price is. On the other hand, when it comes to the things we purchase very infrequently, we often have to do research to determine what a good value is.

Investing is a lot like our infrequent purchases. Most of us don’t have an intuitive sense for what the fair value is for a specific security. Therefore, to get a good value, we would have to do a lot of research.

Unfortunately, there are many things that make calculating a fair value difficult.

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  • Companies are very complex entities and there is a lot of information that can be used to determine fair value
  • The information you do have will always be incomplete, because not everything is public
  • There is no universal consensus on how to use the information to determine fair value
  • Emotional sentiment can alter the fair value substantially for long periods of time. It’s like what happens to the price of roses around Valentine’s Day, but with no defined start or end date.

What should an investor do?

So, what does this mean for us as investors? I would argue that for most of us, it means we would be best served to not select individual securities and should instead invest in index funds that track the market. Where many people struggle with this is they believe they should be able to get a better than average deal, just like they do when purchasing merchandise.

The irony when it comes to securities is getting the average price yields a well above average outcome. This is because of the costs associated with trying to beat the market. To draw a final analogy with purchasing goods, imagine you had to pay a commission to a personal shopper to buy things. Unless the personal shopper saved you more than the difference between the average price and their commission, you would actually do worse than average. The reality is about 85% of the people actively selecting securities aren’t able to overcome the “commissions” they are paying.

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