The unexpected for investors is often a flaw in their analysis or something that could not have been anticipated.
In investing circles, this is known as the margin of error and it is most often used by value investors.
Here’s how investors use the margin of error.
Let’s say you have determined that stock XXX is being under valued by the market.
The current price is $25 per share, but your analysis suggests that $35 per share is a reasonable price and attainable.
This might look like a simple decision – buy at $25 per share.
However, because the market has significantly under valued the stock, you are cautious that you may have made a mistake in your calculations.
Rather than buy at $25 per share, you set a buy target price at $22.50 per share or 10 percent under the current price.
This 10 percent reduction is your margin of error.
If you were wrong about the fair value of the stock or something unanticipated happened, your entry point ($22.50 per share) gives you a cushion if the price does not hit $35 per share as you anticipated.
For the stock to move from $25 to $35 represents a 40 percent increase or 10 points.
However, if the stock only moves to $30, you will still make a profit, but not as big (20 percent gain).
If you buy at $22.50 and the stock only moves to $30 (instead of the $35 you anticipated), your profit margin will be 33 percent.
By using a margin of error you have bought yourself some insurance against things not turning out the way you planned.
Like all value investors, you must be patient to allow the market to move the price more closely in line with the stock’s underlying value.
I used 10 percent as a margin of error in this example. Where you set your margin of error depends on your tolerance for risk and the possibility of something unexpected happening.
The margin of error is a conservative way to help earn a profit even when prices don’t reach the levels you anticipated.
Follow me on Twitter