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What's The Investment Spectrum? Glad You Asked

To succeed as an investor, you have to develop a sense of the investment spectrum. This is a mental conception, or construct, that helps you understand the tradeoffs you face as an investor.

The investment spectrum differs from what you find in the physical world, where the two ends of most spectrums are opposites of each other. Those opposites-hot vs. cold, high-frequency vs. low, and so on-are generally easy to spot and measure. In contrast, the two ends of the investment spectrum represent extremes that are different but not opposites.

These extremes often seem easy to measure. But that is an illusion because the length of the measuring tape keeps changing. It depends on what's happening in a particular investment, or elsewhere in the investment world.

For instance, consider the p/e ratio (the ratio of a stock's price to its per-share earnings). Many investors start out with the idea that a low p/e ratio is a big plus, because it puts you at the low end of the risk spectrum. After all, a low p/e means you are paying less per dollar of earnings, so you are obviously getting a bargain.

If only it were that simple. In fact, there's little consistency among stocks with low p/e's, and only a handful offer true bargains.

Source: multpl.com

Some trade at a low p/e because they are little known or poorly understood by investors. If these stocks grow and prosper, their earnings can rise. This is likely to attract investor attention. That means investors are likely to bid up their share prices, so their p/e ratios can rise along with their earnings. That's a potent combination and can deliver huge gains.

More often, stocks trade at low p/e's because investors have doubts about their current or future profit potential. If these doubts turn out to have substance and their earnings shrink, their p/e ratios shoot up. This turns that supposed low-p/e "plus" into a minus. If the profit shrinkage continues, it leaves them vulnerable to further losses.

Other investors have less interest in low p/e's. Instead, they focus on growth, and they are willing to pay up for it. That means they may be willing to pay a high p/e ratio-30.0 to 40.0 or higher, for example. When a stock trades at a p/e in or above that range, it needs to report sharply rising earnings to justify its current stock price, let alone go higher. If its earnings growth slows-or worse, levels off or falls-high-p/e stocks can suffer a devastating fall.

One immediate lesson to take from all this is that a p/e ratio is just a starting point. You need to look deeper and wider to make sensible, profitable investment decisions. When you do that, you'll find fault with many stocks that have exceptionally high or low p/e's.

Most successful investors find that they take on less risk and make higher profits by investing mainly in the middle of the p/e spectrum. Today, I'd say that would include p/e's between-very roughly-10.0 and 25.0. You need to be cautious about buying stocks with p/e's below 10.0 or above 25.0. In stocks with unusually low or high p/e's, surprises tend to be unpleasant.

You'll find this situation isn't unique to p/e's. No matter what investment measure you look at, too high or too low a score can signal either danger or a bargain. Far better to build a portfolio of stocks from the middle ground of a variety of investment measures. It will give you much better long-term results, with a lot less stress.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.