Given you are reading this, it appears that once again, the world did not end. How should the absence of world ending cataclysm affect investing.
A super-simplified primer of things to know:
- Stocks are fractions of real businesses.
- Whether you own 100% of the business or a millionth of 1% of it, you must know how the business works in order to value it.
- The value of the business is the net present value of a) how much you will get back when you sell it, plus b) dividends in the meantime. Both of those depend on cash earnings.
- In financial statements cash tends to be real, everything else is opinion.
- A stock is not money, but it usually can be exchanged for money.
- The stock market is how you trade it back for money or how you trade money for the stock in the first place. While it is I Estes, it is not money.
- The stock price in the market is the number that will be used to do the trade. That price is determined by an auction. The number is a function of bidders thoughts and their enthusiasm. In the short run, the price of a stock in the market can be poorly correlated with business value.
- Investors trade their cash for stocks when they believe the price is lower than value. That rightness of the decision rests on their ability to assess value and their ability to understand how the market prices securities. This method tends to be rational.
- A trader or speculator cares less about value. Indeed they may not know what the company does, but they estimate that they know how other people in the market will behave. They assume they can interpret news better or sooner than the others. This method tends to be rational but based on the psychology of crowds rather than business fundamentals. Acting on crowd psychology is error prone.
So, what should someone do about all that?
If you are a trader, you must be able to anticipate how much people will pay for a stock sometime in the future. (Usually near term.) People are emotionally complex and understanding what they will fear or want even a month from now is problematic. Guessing how they will behave in the more distant future is near impossible.
If you are an investor, you need know how to value the business. It is better if you have knowledge about how people create the price, but you could live without that knowledge. If the price offered in the market is substantially lower than your value number, you buy. When it later becomes substantially higher than your value idea, you sell.
The issue is that to start with money and end with money, there are two decisions. One to buy and one to sell. Objective evidence helps.
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.