Bargains are the key to investing

People's instincts about what makes a purchase worthwhile have some harmful side effects when applied to investing. However, overcoming these instincts can be very profitable, which is what the powerful concept known as 'Value Investing' is.

There are two opposite instincts that govern how people spend their money. One is to buy expensive things in order to signal their status, and the other is to get a good bargain. Ideally, we would like to combine both. We would like status-symbol possessions that normally cost a lot, but we would like them to be a good bargain just for us. That sounds like an impossibly good deal, but then the fun of getting a deal is at its highest when it's good.

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It's a basic human instinct to use the price of something to judge its intrinsic value. People express their wealth and their status in society by buying things that are more expensive. Whether it's something trivial like a shaving blade or some substantial expense like a car or even a massive layout of a house, rich people spend more on the same kind of things. This behaviour is a part of human nature and really, there's nothing fundamentally wrong with it. People acquire wealth to signal status, and it brings them a feeling of fulfilment to be able to do so.

This belief that expensive things are better, shapes human behaviour in some surprising ways. The most surprising example that I have found is that in drug testing, patients have been observed to improve more if they are told that the medicine that they are being given is more expensive. It sounds unbelievable, but the same medicine appears to have a more beneficial effect on disease if the patient believes that it's more expensive.

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It means that although people instinctively look for bargains, they don't necessarily make correct judgements about the inherent value of things. Instead, they use price itself as an input for whether something is a good bargain. That sounds like circular logic, and it is.

If this is what human nature is like, then what is its effect on investing? The more a stock rises, the more people believe, instinctively, that there must be something good about it. In a sense, the cause and effect are reversed. At its heart, Value Investing is the style of investing that does the opposite. There are a variety of ways of defining value investing, but they all boil down to the fairly simple concept of buying quality stocks that are undervalued. It's about buying cheap and being aware (and suspicious!) of the idea that if something is expensive, then it must be good.

Look at it from another way. Investing in a stock is an exercise in accepting uncertainty. You can analyse the likely future and hope that the company will do better and the stock will rise. When the stock rises, you will be able to sell it at a higher price eventually. These future events are not dependent upon anything you can do. Anything could happen to the company, its market, its industry, the country's economy and indeed the global economy that could derail your expectations.

All this is in the future, and you have no control over it. The only thing you can control is the price at which you buy the stock, or rather, whether you buy it at all at a given price. Everything that happens in the future gets shaped by the price. The exact same investment can be good or bad depending on what your price was. It is simply not possible to judge an investment without the context of its price, at least in the positive sense. I mean, there are equity investments that are bad regardless of the price. However, there aren't any investments that are good regardless of the price.

This is why the instinct of buying only at a bargain - and not investing unless there is a bargain to be had - is the most important thing in investing.

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