Arguably the biggest mistake investors tend to make is overestimating their own skill in trying to outperform the market. This self-affirmation bias, moreover, is most dangerous when markets are climbing higher. Made confident by rising stock prices, investors develop a false since of confidence that they can pick better stocks than can the collective group. It's quickly forgotten that a rising tide lifts all ships.
With that in mind, investors can largely sidestep the mistakes created by a false sense of confidence if they engage in a simple exercise: asking, "What if?" The problem is, very few investors consider the "what-if" scenarios and focus only known variables at the time. Tuesday's market decline was a quick reminder to investors that, given today's macro risks, a huge market advance -- such as the 10% rally we've seen so far in 2012 -- could well disappear in a matter of days.
So the question to ask about your investments now is, "What happens to this business if Europe explodes?" Another: "What if U.S. economic growth stalls?" The quick answer is that markets will decline, and in all likelihood so will most share prices. If you own stocks that aren't trading at overvalued prices, then you can take comfort that a decline today will give you an opportunity to add to your position.
For example, if Bank of America (BAC) falls below $7, I'm buying, because I'm focused on the value of this bank a couple of years from now. The loans the company is making today, despite the low volume, are profitable. The company's wealth-management business is thriving, and the company is going to a have a significantly reduced cost structure.
If we see a real correction in the broad market, I may also finally be able take a nibble at Chipotle (CMG) -- which, I regret to say, I passed up back in 2008 and 2009. It's wishful thinking to hope Chipotle will trade close to those prices again, but that's not what I'm seeking. Quite simply, I know this: If the economy explodes, people will still line up at Chipotle for lunch and dinner, just like they did in 2008 and 2009.
However, no matter the excitement for names such as Pandora Media (P) or Zynga (ZNGA), these types of recent IPOs should be avoided at all cost today. The valuations bestowed on these names is based on a hopeful promise of exciting things to come. Excitement may indeed come, but it's unlikely to translate into profits that justify the current valuation.
Zynga, with market capitalization of nearly $11 billion, is worth twice the valuation of Advance Auto Parts (AAP), a leading auto-parts chain with thousands of stores and more than $6 billion in annual sales. Zynga's annual revenue of $1 billion, and no profit, hardly justify the current valuation of its shares. This is not 1999; Apple (AAPL) has set the new standard for a high-growth tech company. Apple's profitability is almost doubling each year, yet it trades for 15x earnings, or 10x forward earnings, not taking into account the cash on the balance sheet.
Investors need not get emotional or jittery. The market will most definitely experience periods of volatility in 2012 -- Europe will see to that. But the U.S. economy is on the mend, and so is the stock market. On a selective basis, stocks are attractive today. As volatility rears its ugly head throughout the year, shares that have no business trading at the valuations they now command will see their prices evaporate, leaving overconfident investors to hold the bag.