The Risk of Investing in Value Trap Stocks

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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Investors often buy value stocks because they believe it is an investment which provides good value for their money. In other words, they believe (or are certain) that this undervalued stock will be able to pay them handsome returns in the future, often based on the reason that it is "so severely undervalued" now that the only way from here is up.

Undeniably, this investment philosophy has its merits but whether such an investment is actually able to provide certainty and predictability is a completely different matter, as the value of a stock is one aspect but having certainty is another. Buying a severely undervalued company hoping it can somehow turnaround and miraculously recover does not provide certainty. Buying such undervalued stocks just because they are "cheap" does not justify the price paid. Oftentimes, many cheap stocks are cheap for a reason, such as changes in the company's business fundamentals or government policy shifts that would hamper the company's growth. Such would be detrimental to the company's financial health and earnings over time, harming investors who continue to invest just because the company seems to be severely undervalued.

This is where the value trap happens, which is a common mistake many investors looking for "bargain" deals in the stock market end up succumbing to. Instead of buying good quality companies, they end up chasing after the low quality stocks just because the price is cheap.

Alibaba — Value Trap Example
Alibaba is a good example of a value trap stock that many have fallen prey to, having experienced a massive sell-off over the past 3-4 years and yet to recover since then. Whether Alibaba recovers back to its highs, your guess is as good as mine. However, one thing is certain — it will take time.

If we assume Alibaba is able to recover back to its all-time highs of $309 back in October 2020, the first question to ask is whether this is even plausible or not. And if so, how long would it take? Oftentimes investors tend to hold on to deeply oversold and "undervalued" stocks like Alibaba for years, in hopes that it will recover. But in the process, they tend to disregard the opportunity cost of doing so. The question they need to ask themselves is this: "if I continue to hold on to my $X investment in this stock for X years, will I simply be better-off taking losses now and buying into the S&P 500?" If yes, then the decision is clear: bite the bullet by selling and taking loss, before reinvesting those funds in the S&P 500 or elsewhere with better and more certain growth prospects.

Sunk Cost Fallacy Mindset

However, this decision is often a very difficult one to make because as humans, we are prone to factoring sunk cost in our decisions. Just because we have incurred $X amount of loss in our bad investment decision does not mean that we should continue holding on to it.

In fact, many times such failed investments may never recover back, but because we are under the impression that since we have already burnt $X and spent X amount of time on our investment, we should just continue on and remain invested all the way regardless of the future cost and benefits, or worse still, invest even more money into the bad investment decision to lower our average cost.

In doing so, we are not only making a financially unwise decision but also short-changing ourselves of the opportunity of learning an important lesson in investing: when to cut and take losses. Accepting the fact that we have made a mistake and incurred a financial loss is the first step. This should be preceded by selling the investment and reinvesting it elsewhere, which is often the most difficult part as many people are reluctant to cut losses and move on to new investments. After cutting losses, we should move on from our mistakes, and most importantly learn from them to make better and more effective decisions in the future. If there's anything we can learn from our bad investment decisions, it's learning how we can avoid them in the first place. 

To make a costly investment mistake is one thing but to make the exactly same mistake a second time or worse still, a third or fourth time, is inexcusable and going to be far more costly than imagined. Thus, at the very least, the takeaway we should have from any bad investment decision is learning how to identify and avoid such similar decisions again in the future. Exercising greater caution and carefulness in our future investment decisions is key to avoiding making the same mistake we made before.

My Investment Philosophy
One lesson I have personally learnt over the years that has become part of my investment philosophy is to "never lose money" based on the famous quote by Warren Buffett.

"Rule #1: Never lose money. Rule #2: Never forget rule #1.” — Warren Buffett

This rule is a key and foundational aspect in value investing because the whole purpose of investing in the first place is to make money. So if one were to lose money, this would be contrary to the whole purpose of investing in the first place. Parking your money in risk-free assets would have allowed you to grow your money without taking on any risk. Therefore, the reason why we take risks and invest is so that we can earn higher returns than merely the risk-free rate. But if we were to lose money (especially even after years of investing), then we would have been much better-off not investing in thr first place. This is why Buffett's quote is at the core of investing. The moment we break Rule #1, we need to make twice as much returns as before to first recuperate our losses before being able to make actual returns. In other words, losing money in investing is like taking one step back before taking two steps forward just to move one step forward. Therefore, the key thing is to avoid losing money in the first place, which would place us in a much better and stronger position to make more money.

While making losses could serve as valuable lessons for us to avoid making such mistakes in the future (and in turn make better decisions), this is only true if the losses we make are not that significant and are made early in our investing journey. If we were to incur massive losses, it would take very long before we are able to recover from them, or worse still, if the losses were made late during our investing journey, then the losses we suffer would be extremely detrimental to our finances and possibly even our retirement if we are older.

Conclusion
Thus while losses might serve as good learning points for us, controlling the losses and making them early in our investing journey is important to secure a brighter and more certain financial future. To avoid losing money in the first place, I would rather pay a premium for good quality companies and businesses than invest in heavily discounted businesses that have deteriorating economic moats or have had their business fundamentals severely changed. 

Also, it is extremely important to invest in businesses and companies whose business model we know and understand. If you are unable to understand the business model of the company you plan to invest in regardless of how cheap, the wise decision would be to avoid such companies in the first place and stick with simply buying ETFs tracking the market index. Doing so requires no knowledge of the companies in the ETF because it is already so well-diversified and ETFs are designed by nature to automatically reduce or eliminate the underperforming businesses, allowing your investment to grow and flourish over time without needing to monitor it or spend time understanding the business.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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