Emotional Investing - The Dangers of Ignoring Stock Fundamentals

Emotional Investing - The Dangers of Ignoring Stock Fundamentals

February 08, 2021
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Fundamental analysis is the investor’s version of going back to basics. It requires thinking about the big picture of a company before investing in them instead of solely focusing on how their stock performance fluctuates from day to day. The various factors that influence the strength of a stock’s fundamentals include the industry’s prospects as a whole, its competition, the quality of management, its income and revenue growth potential.

So, what does it mean when people say a stock has strong fundamentals? It means that they’ve analyzed any data which are expected to impact the price or perceived value of that stock, not including the trading patterns of the stock itself, and based on this research have deemed it to be a sound investment. When it comes to fundamental analysis, this is some of the common data that are examined…

  • Cash flow
  • Return on assets and equity
  • History of profit retention for funding future growth
  • The soundness of capital management for the maximization of shareholder earnings and returns
  • Price to earnings, price to sales, price to book value

All of the data needed for fundamental analysis can be accessed by the public and is usually found in a company’s reported financial statements. The goal of this analysis is to determine if the market has priced a stock correctly. If an investor determines that a stock price is undervalued, they can actually use this knowledge to make money for themselves over the long run.

Despite that, not everyone assesses the strength of a stock’s fundamentals before investing. There are also technical analysts. While fundamental analysts ignore the trading patterns of a stock and focus on its intrinsic value instead, technical analysts are all about trading and price history. They look to things like trading signals when evaluating a stock and use what they know of its history to attempt to predict its future.

The issue here is that it becomes easier to fall prey to herd mentality. In other words, a technical analyst is much more likely to buy a stock simply because everyone else is doing it. In fact, that’s part of their strategy because they think increased demand is bound to lead to higher prices, and to be fair, that is sometimes true.

Conversely, true fundamental analysts don’t scare easily. They believe that making decisions based on comprehensive research and long-term value projections is the way to go. Because of this, they will stick with their stock choices unless they see a fundamental change, thus avoiding the temptation to make snap decisions based on day-to-day market fluctuations.

While it’s true that there isn’t a one size fits all answer for how to pick stocks, there is evidence that strongly suggests that the market reflects fundamentals. That being said, sometimes new information will be presented that will change an original fundamental analysis. In situations like that, don’t be stubborn. It is important for all investors to be flexible.

The danger of ignoring stock fundamentals, and especially of forgoing any type of in-depth analysis before investing, is that you may start making decisions based on emotion instead of logic. There are three main emotions that can negatively impact your returns: fear, greed, and frustration. The key to making returns is patience. It’s all too common for investors to get frustrated by the performance of a stock, sell it, then see it surge afterward.

Despite the fact the investments fluctuate on a daily basis, the long-term trend of the stock market is up. According to McKinsey, in the past 35 years, the median return on equity for all US companies has been a very stable 12 to 15 percent. This is why, if you use fundamentals to pick stocks, you should be confident that they will perform, and therefore willing to wait.

Sometimes the emotions that may affect your investment decisions aren’t even your own. Because humans are herd animals, it’s only natural for us to reflect the emotions of others. We see this happen in the stock market all the time. It’s important that you do not turn your back on an investment you made because of fundamental analysis solely because of the actions of other investors. After all, if they jumped off a bridge, would you follow?

You may have noticed a stock before the rest of the herd. That doesn’t mean you're wrong, especially if you’ve done your research. In fact, this kind of opportunity can lead to returns for you. A study published in the Journal of Financial Planning found that investors who use a behavior-modified approach to investing that removed emotion saw returns up to 23 percent higher over 10 years. Regardless of what the herd is doing at any given time, it is unlikely that they will impact the stock market enough to make the market deviate from intrinsic values, so it’s your job to remain calm.

That being said, performing a fundamental analysis is a lot of work, especially for inexperienced investors. When the market is up, it’s easy for investors to make money with little experience, and sometimes even with luck. However, during the hard times, true knowledge about stock fundamentals and the willingness to stick with sound investment decisions is imperative. You may want to consider enlisting the help of a financial advisor.

A good financial advisor will create an investment strategy that is based on your own unique situation, then they will continuously operate based on that agreed upon plan. Don’t be a faceless sheep; you’re an individual and have the free will to make different decisions from the rest of your herd. Stop (let’s be honest) guessing about which stocks will make you the maximum returns with minimum time spent and start letting the professionals do the hard work for you. In the end, thinking about your wealth long-term and bringing some consistency into your financial picture, with or without help, is likely to benefit you.