Are you playing the greater fool theory?

Westpac Banking Corp (ASX:WBC) has hit a new all-time high but perhaps the sellers know more than the buyers!

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With the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) flirting with the 6,000 point level, investors could be cheering any day now when the index finally crosses the mark.

While even at 6,000 the index will remain well short of its all-time high, for many it will mark the end of an era that saw the index sink towards 3,000 in the midst of the Global Financial Crisis (GFC).

While buoyant stock markets are great for helping share prices rise it does at times create heightened risks that the market and individual companies may move into overvalued territory.

This scenario can represent a dangerous time to invest, as historically overpriced stocks eventually find themselves facing a correction to bring about more reasonable pricing which is in line with a conservative assessment of value.

How do you protect your portfolio?

If you are going to invest directly in the share market and own individual stocks, rather than outsourcing your decision making to a fund manager such as Platinum Asset Management Limited (ASX: PTM) there is one important concept to understand.

This concept was best summed up by Benjamin Graham, a man often described as 'the grandfather of value investing', he also just happened to be Warren Buffett's mentor and employer…

"An investment operation is one which, upon thorough analysis, promises safety of principle and an adequate return. Operations not meeting these requirements are speculative."

What Graham's statement ultimately boils down to, is that investing requires the ability to accurately assess the value (or worth) of a business.

Banks are a prime example….

Largely as a result of the huge weighting the 'Big Four' banks command within the ASX, Australian investors have a significant proportion of their wealth tied to these few businesses. With Westpac Banking Corp (ASX: WBC) hitting a new all-time high recently, and its peer group all trending higher this sector is arguably one area of danger that could be bordering on speculation.

When it comes to valuing a bank you have a bewilderingly complex task ahead of you. That of course makes short-cut valuation tools all the more sought after and potentially dangerous. While price-to-book value is no panacea, it is arguably a good rule of thumb for keeping investors grounded. A ratio of around 1.5x is probably reasonable provided the return on assets is above 1%.

If you own an Aussie bank in your portfolio, the question is do you know how its valuation metrics stack up against the price it is selling for? What's more, have you compared how the Australian banking sector is currently priced against its peers in other regions such as Canada, the USA and UK?

Arguably, when analysed against global peers and under historical comparisons, the Australian banking sector doesn't appear particularly good value…

Speculation often means that you're playing the greater fool theory. In other words, you're buying something purely on the hope that there will be some fool out there prepared to buy it off you for more than you paid.

If you'd rather buy a stock based on solid valuation principles instead of speculating that there is a greater fool out there then make sure you have a read of this ….

Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned.  

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