Price vs. Value

Warren Buffett once famously said, “Price is what you pay; value is what you get.”

If I asked you what your house is worth today, you could probably come up with a decent number in short order. You could look up the price for which homes in your neighborhood have recently sold. You could look it up on Zillow. For the sake of illustration, you tell me your home is worth $250,000. That’s pretty close to the average for the St. Louis metropolitan area as I write this.

So, what would happen if I casually offered you $150,000?

A couple of things, more than likely. First, you would chase me off your property with the closest gardening implement you could get your hands on. But the second thing that would happen is the realization that the “price” of your home had just fallen by 40%. Technically speaking, the current price of anything is whatever someone is willing to pay for it at that point in time.

I’m fairly certain there’s one thing that would not happen as a result of my low-ball offer. There’s no way that you would accept it, again, for two reasons: 1) you know that your home is “worth” a whole lot more than what I’m offering; and 2) you probably don’t need the money enough to accept such a ridiculously low price.

The lesson is one you’ve known for most of your life: As long as you don’t need the money, there’s no compelling reason to sell something at a price that is significantly below its value.

Now, let’s transfer that wisdom to the world of investing. Every investment you own – or are considering owning – has two numbers associated with it. The first is its price, and in most cases this number is very easy to find. The price of stocks, bonds, and exchange-traded funds, generally speaking, is somewhere between the “bid” (the highest price a buyer is willing to pay) and the “ask” (the lowest price a seller will accept). The price of a mutual fund is its “net asset value (NAV)” at the end of each trading day.

The other number, of course, is the value of the investment. That’s a much more difficult number to come up with, and it’s much more subject to interpretation. I might refuse to buy a certain stock for my clients because what I perceive as its value does not justify its current price, just as I might truly believe that your home is worth far less than $250,000 because of the Walmart Supercenter I hear they’re about to build next door.

As an investor, if you are going to own equities, you must accept the fact that prices jump around a lot more than values. That inherent volatility is what sometimes gives you the opportunity to purchase shares at a discount to their intrinsic value, and to sell when the price represents a great premium over value.

You might want to keep this concept in mind the next time the market takes a tumble, when equity prices fall sharply across the board. It might be tempting when things get scary, but remember that you don’t need to sell stocks at low-ball prices, unless of course you need the money.

The trick is never to put yourself in that situation. Any money you plan to withdraw from your portfolio over the next five to ten years should be invested more conservatively. That’s the money you’ll tap when you need to pay your bills. Knowing the difference should make you a better, calmer investor.

And I was just kidding about that Walmart Supercenter.