The rational buyer of a business will strive to own a better business rather than a poor one. For example, if there are two corner stores but only one is crowded with customers and it earns far more in profits than the other store, the choice is easy. Maybe even obvious. And given the choice, the rational buyer of a share of a business will also strive to own the shares of a better business rather than a poor one.

Yet in broadly diversified mutual funds and exchange traded funds (ETFs), including index funds that may own thousands of companies, all companies of a particular size, sector, region or other widely-defined category are owned. This includes those that are profitable and those that are loss-generating; those that have shareholder-friendly management teams and those that use company coffers for their own benefit; those that have their financial house in order and those which must routinely borrow to pay off maturing debts, etc.

Warren Buffett, among others, has long championed the ownership of the best quality companies available (his secret is to buy them only when they are available at an attractive price). In his classic 1980 book The Money Masters, author John Train says, Buffett “characterizes traditional diversification as the ‘Noah’s Ark approach.’ You buy two of everything in sight and end up with a zoo instead of a portfolio. The essence of Warren Buffett’s thinking is that the business world is divided into a tiny number of wonderful businesses – well worth investing in at the right price – and a huge number of bad or mediocre businesses that are not attractive as long-term investments.”

          Buffett “characterizes traditional diversification as ‘the Noah’s Ark approach.’ You buy two of everything in sight and end up with a zoo instead of a portfolio.”

Sorting the wonderful from the mediocre and worse requires an understanding of various facets of each business. We offer this abridged list: A company’s position within its industry must be favorable, it should have products or services that are necessary, and the business should have a track record of consistent profit production. Regular and annual growth in profits is not a prerequisite – the business cycle makes that nearly impossible (absent financial embellishments perpetrated by less than honest management teams) – but it is preferred. A high quality company usually produces a clear progression of earnings growth over many years. The excellent business should also achieve high marks for its financial health (balance sheet strength), return on capital employed within the business (profitability), and the ability to produce free cash flow which it then uses in a shareholder-friendly manner (including opportunities for internal growth, complimentary or “bolt-on” acquisitions, paying down debt, increasing dividends, or buying back shares – and each of the aforementioned to be employed only when appropriate).

It is important that the company’s top executives maintain goals that are aligned with shareholders, that they have a vested interest in the business, and are not using the company as their personal piggy bank. Furthermore, good management tends not to spend money on pursuits of empire building (growth for its own sake), instead focusing on protecting profitability for the long run. Too many companies attempt gains in the short-run, kowtowing to Wall Street’s consistently myopic desire for quarterly profit growth. Said Warren Buffett in Berkshire Hathaway’s 1979 letter to shareholders:

“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.”

Yet quality is just one factor that that gets diversified away in diversified mutual funds and ETFs. The buyer of an over-diversified mutual fund or ETF is not just acquiring the shares of both high and low quality businesses, but also is paying prices both high and low for those businesses. Selectivity and the ability to pay a rational price – or better yet a bargain one – is lost.

Within each index, share prices are constantly bouncing around. In fact, the market price for a share of a business fluctuates far more than the underlying value of that share or, said another way, the actual value of the business itself.

Consider Alcoa. Founded in 1888 and earning its moniker from the phrase the “Aluminum Company of America,” Alcoa is a venerable “household name” company. Annual revenues of $23 billion are essentially unchanged during the past three years, assets have fallen from $40 billion to $37 billion during that time, and net tangible equity (what the business is worth if you take its tangible balance sheet assets and subtract all liabilities) was $8 billion on 12/31/12 and is $7 billion as of 12/31/14. Importantly, profits were meager in 2012 and again in 2014. Roughly only 1% of revenues make it all the way down to the “bottom line” to be counted as profits. This is not a company that reaches our standard of a high quality business.

During the years 2012 through 2014, Alcoa’s share price fluctuated more than 100%, from a low below $8 to a high above $17. Concurrently, the market value of all Alcoa shares fluctuated between $9 billion and $21 billion. In just three years, market participants “valued” Alcoa at various points across a range of 133% its lowest valuation and by a difference of $12 billion. Recall that there were almost no fluctuations at all in the actual metrics of the business!

Why is this price range so wide? Because the company’s shares are held and traded by thousands of financial institutions and millions of individuals. Each buyer and seller has his or her own reason (and sometimes not much of a reason at all) for buying and selling. Turn on CNBC on any given day and you will be bombarded with “reasons” to take action. Maybe bonds are said to be more appealing one day or emerging markets hold better promise. Furthermore, buyers are willing to pay a higher price when they are optimistic compared to when they are fearful about the future. And sellers are eager to unload their shares when they are scared about the prospects for the company, financial markets, local economy, world economy, political election, geopolitical situation… you name it.

If the value of the underlying business is not wildly unstable, then we know that these wide price fluctuations are not rational. They are in large part the product of the emotions of millions of market participants, each one trying to outguess the short-term movements of the next market participant.

Sir John Templeton, legendary value investor of the 20th century, suggests a better approach. “Help people. When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell.”

          “Help people. When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell.” – Sir John Templeton

“Helpful” advice aside, it is common that many of the reasons behind one’s transactions in stocks are not influenced by a careful evaluation of what the underlying company might actually be worth.

Our quest for value, and thus future profits, in common stock centers on our appraisal of the likely returns to us as an investor over the next several years. No one can predict the exact price of a stock ten days ahead of time, much less ten years out. However, to invest rather than speculate it is necessary to make an informed estimate of the probable range of future pricing over the long run.

It is possible to estimate a range of future market value intelligently because, to paraphrase Ben Graham, it is not necessary to know the exact amount of earnings to determine whether a company is likely to be profitable in the future. (Buffett, in a less than politically correct moment, referred to this by saying, “If somebody comes to the door, whether they weigh 300 pounds or 325 pounds, it doesn’t matter: they’re fat. We don’t need to know more.”) And it is not necessary to predict future valuations, e.g., a company’s future price-to-earnings (“P/E”) ratio, with exactitude to make a reasonable projection of future market valuation.

The price paid by an investor for their shares plays a large role in the return that investor can expect from their investment. This is true regardless of the company’s quality, position in its industry, or “story.” High quality companies can be poor investments if one pays too high a price. We need look no further than the overpriced markets of 1999-2000 and 2007 for countless examples of household-name companies that cost their investors dearly by subsequently losing tremendous sums of money.

Paying a price below that which the investor believes the company is actually worth over time provides the investor with what Ben Graham called a “margin of safety.” Doing so does not guarantee success for each investment, but it increases the likelihood that a portfolio of such companies will produce satisfactory long-term results. And, importantly, with its goal of keeping the investor away from overpriced stocks, it may help to keep this individual safer than his or her peers in a significant market decline. This is an often overlooked point, especially during rising markets, and it usually concerns most investors only after it is too late.