Investing in the stock market is not as simple as following a prescribed formula or going down a checklist.
The stock market is a dynamic and challenging environment that defies the simple strategy, especially for investors looking for a quick profit.
Unlike the weather, predicting the value of an individual component (stock) is actually easier for the long term than it is for the short term.
In the short term, any number of factors that have nothing to do with the company or industry - bad economic news, bad political news, a bad hair day for key traders - can move the market and individual stocks.
Successful long-term investors in the stock market know that identifying great companies and buying them at the right price is the best chance for long-term success.
It is, however, not a formula for predicting short-term success.
One of the keys to this strategy is buying the stock at a good price, which will give you the best opportunity to make a profit.
Successful stock investors, like defensive drivers, always expect the unexpected.
The "unexpected" for investors is often a flaw in their analysis or something that could not have been anticipated.
Successful long-term investors acknowledge that they cannot know everything there is to know about a company or its stock. To protect against the unknown, investors use a strategy that helps them identify the correct purchase price for a stock.
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. This is just an example. You may want to set your margin of error higher or lower depending on the stock and your tolerance for risk.
Using a margin for error requires patience, since the stock must move down (usually) to your price before you buy. This may mean you pass on some potentially great stocks because they do not meet your margin of error goal.
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.
