It may seem like a time for crowing.  The position advocated in these posts, that GoPro and Tesla had reached values that were unsustainable, has been vindicated.  But it is a better time to take stock in the relation between fundamental valuation and investing, than for self-congratulation.

Making money from fundamental valuation requires the confluence of three factors.  The first is that once the investor completes the fundamental valuation the estimated value differs significantly from the market price.  This is actually likely to be quite rare.  Assuming both the investor and the market are reasonably rational, the two valuations will typically be quite similar in which case there is no incentive to invest.

If the two valuations differ, then it must be the case that the investor is right and the market is wrong.  Think for a moment what this means.  It means that one investor is able to assess value more accurately than the weighted average of the valuations of millions of investors reflected in the market price.  How likely is that to be the case?

But even if the investor is right and the market is wrong, the investor does not make money off the discrepancy until the market recognizes the error if it ways.  If the market gets even more wrong, the investor loses money.  This leads to the old Wall Street adage that, “The market can stay irrational longer than you can stay solvent.”

So even in this moment of glory regarding Tesla and GoPro, the message is to be cautious and humble.  The circumstances under which any investor, even Warren Buffett, can identify meaningful market misvaluations are likely to be rare.  Over-weighting a portfolio to what you believe to be misvalued securities might lead to nothing more than bearing unnecessary risk.

By Brad Cornell, Professor of Finance at Caltech

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