People like cause and effect. People misuse reasoning tools to find and rationalize the causes of stock price changes. Price is, at best, an approximation of value and at any time there may be many factors involved in its creation.
The recent market meltdown is an interesting study in psychology. How does it happen that people misinterpret price signals?
Let’s look at some factors about how things work so far.
- Daily stock market results do not create a normal distribution. (Bell curve) It is like a bell curve that is skinny in the middle and lumpy at the extremes. If you use statistical analysis that pretends it is a normal distribution you will have occasional strange results.
- The lumpy part on the gain side of the chart is greed. The lump on the left is fear.
- Greed and fear are not fundamental to the value of a business but they are fundamental to the price of its stock.
- Apple closed business on 21 August at $111 making the company worth $632 Billion. Perhaps they made some colossal mistake over the weekend because it opened Monday at $92 for a market value of $524 billion. Managers cannot make $100 billion mistakes so possibly the subjective fear in the hearts of traders is to blame.
- In Apple’s case, it was back to $112 by noon Thursday. That recovered the $100 billion plus $6 billion more. Managers are not that smart. Again the pricing mechanism causes the change. Greed in this case. Apple, as a business, did not change in those 6 days.
If a stock buyer or seller is driven by signals from the amygdala, the primitive brain, the part that governs fight and flight, should we expect higher brain, rational outcomes? Probably not. So what to do?
Notice that a stock has two pricing mechanisms.
- The lizard brain mechanism that thrives on emotion, incomplete information and the activity of the crowds.
- The rational mechanism that relates to the nature of the business, its products, its management, its financing, and its industry, all assessed against the backdrop of the world’s economy.
Method 2) is difficult and demanding work. Method 1) is easy. Which do you suppose was applied over the weekend of 22 and 23 August?
If you sold Apple at the open on Monday morning and bought back at the open on Thursday when the fear had subsided, you would have lost 18% of your money. Clearly, the investigate, then buy and hold method would have served you better.
There is an enormous amount of information that points to buy and hold as the proper methodology for most investors.
The short game can make money too but those that play the short game need some skills:
- To have information sooner than all the others,
- To have accurate information,
- To know what the information means,
- To understand how the others will relate to that information once they discover it,
- To accurately estimate the speed with which the others will act,
- To themselves act correctly twice. Getting in and getting out of the position.
I have a seen only a single person with most of those skills. The application of them, while generally profitable, was not without spectacular failures.
Buy and Hold seems to work, but it is hard work and boring. The other techniques of “Shuck and Dive”, “Run and Hide”, “Duck and Cover” may not fulfill your purpose.
Few are able to make money based on better information, sooner and with an understanding of how people will react to it. Price is therefore, a poor indicator of value. If you understand value, then price can help you. Sell to the greedy at high prices and buy from the fearful when low.
But, you do need to know what the real value is and you need someone to talk you in off the ledge when the others become irrational.
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Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.