When we decide to purchase a security (invest), we often think of all the reasons the security will provide a positive rate of return for our portfolio. We usually research and find evidence as to why the security will appreciate in value over time. This evidence may influence our decision to invest in a security and/or provide confirmation that a past investment was a good one. Rarely do we invest in a security and ask ourselves, before purchasing, how we could be wrong.
Evaluating ways in which a security may lose us money is not a desirable task, but it is necessary part of a thoughtful investment plan. This is especially true for securities that have very high growth potential and high valuations. No investor is correct 100% of the time, therefore it is important to understand how you could be wrong, at what it may cost you. For every security transaction there is a buyer and a seller. So as you are confident in the future gains of a given security, another investor is not, and chooses to sell it to you. One of you is going to be right.
An Example
A pro/con list may be helpful when evaluating securities. The pros are the ways in which the company is going to do great and the cons are ways in which the company may not do as well as expected. To illustrate a pro/con list, I will use Uber, a private yet well-known company, as an example. These are my own opinions and serve only as an example of the types of questions to ask of any investment.
Uber has a current valuation of over $50 billion, which is greater than 75% of the companies in the S&P 500. It is a classic high growth, high valuation scenario.
PRO – Reasons Uber is attractive
– Uber is optimized for the business traveler
– Efficient, digital way to get a ride (App)
– Schedule a ride to pick you up within minutes (E-Hail)
– Cashless, paperless transaction
– Drivers are rated. Bad drivers are weeded out
– Uber users love it, they are raving fans
– Growth has been significant (doubling revenue within 12 months)
– Huge potential to change entire transportation (taxi) industry
CON – Questions to ask yourself
1. How does market saturation change the growth prospects? How about competition from others such as Lyft?
2. Will the taxi industry become extinct, or will they make changes that make it difficult for Uber to continue to take market share?
3. If Uber users continue to grow significantly, will they be able to find enough quality drivers and pay them a decent wage to satisfy the demand?
4. What if the government rules that Uber drivers are employees (not contractors), which would raise the cost of Uber doing business?
5. What about traffic? As congestion gets worse in metropolitan areas, how is that likely to affect the Uber driver? Does there come a point where the Uber driver does not have time to make enough rides to earn a living? Could that cause Uber to raise prices significantly higher than the competition?
Key Takeaway
Before you purchase a security based on how great a company is (or will be), be sure to also consider scenarios that could result in an undesirable outcome.