The answer is very simple. One of our greatest human fears is our fear of the unknown especially when the unknown is connected to our hard earned savings and investing!
So how do we overcome our fear of the financial unknown? We create mental anchors that help us to overcome our fears. We design a method to measure the unknown and, maybe even, the unknowable. These mental anchors give us a basis for making a decision. In the case of investing, they help us to make the decision to invest or not invest our hard earned savings.
Example: If you’re told to invest $10,000.00 of your savings in the common shares of a particular company, currently trading at $10.00 and you are also told the shares could be trading at $7.00 or $13.00 in 12 months, this is a difficult decision. We perceive the unknown risk as high. Our savings could be worth $7,000.00 or $13,000.00 in 12 months. It is almost like the flip of a coin – heads we win, tails we lose.
But, if on the other hand, it’s recommended that you invest $10,000.00 of your savings in the common shares and the analysts have determined that the shares should be trading higher in 12 months and your investment should be worth $13,000.00, this is a much easier investment decision. What if the analysts write a 10-page research report explaining their research by using a number of mental anchors supporting the share’s 12-month Target Price? They show you the estimated Earnings-Per-Share, Book Value-Per Share Price, estimated Cash-Flow-Per-Share, low Price-To-Earnings Ratio, Estimated Earnings Growth, Estimated Potential Corporate Acquisitions, etc. All of these are unknown today and maybe even unknowable, but they provide you with the mental anchors you need to make the decision to invest your hard-earned savings and overcome your natural fear of the unknown and unknowable.
This is not say that the analysts are wrong in their analysis and that their research should not be read. After all, investors need to make decisions and in the absence of the company selling its assets and paying the net proceeds on a per share basis, analysts are attempting to provide guidance for valuing common share prices surrounded by unknowns.
By understanding that estimating the value of a common share is extremely subjective and by no means definitive, we are better able to manage the investment selection process and the inherent investment risks that accompany the unknown.