Why You Should Watch Out For Value Traps
The day you have been waiting for happens. You find an investment that could double or triple your money in a short amount of time but is it too good to be true? You might have found a value trap which would be very bad for your investment. A value trap is an opportunity to acquire an asset that is relative to market price that could offer extraordinary returns but it turns out to be too good to be true. There are a number of ways spot a value trap.
One classic example of doing your homework to find that what appears to be a value trap is not, in fact, a value trap is the American Express salad oil scandal of the 1960’s. A young Warren Buffett made a lot of money – money that went on to serve as the basis of his Berkshire Hathaway fortune – by calculating the maximum potential damage the credit card company would face if everything possible went wrong, realizing investors had become too pessimistic. The business would be fine.
You should avoid value traps at all costs. One way is to buy ETFs only so you are never buying one stock which limits your risk. Another way is to do your homework and figure out why the owners are selling. If you determine the business will thrive again based on your homework then it is most likely not a trap. Remember to think about changes in the industry. If you invested in a newspaper in the late 90s because it looked cheap, you weren’t considering all the factors.
See the ways in which you could spot a value trap and either make or break a lot of money.
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About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.