It is easy enough to believe you are an investment genius.
In the short run there is just a single factor required to be an investment genius. A bull market. Almost anyone can invest successfully when the market is rising. People begin to attribute their success to factors, that while apparently real, are just manifestations of the underlying strength of the market.
The problem comes when the market changes. And that happens. So in the long run other methods are required.
Understand where prices come from
In the stock market there are always two prices.
- What the stock is worth given its business factors. Things like cost leadership, free cash flow, market share, financing choices, income distribution choices, strategic management, innovation, and operational ability. Some would argue that free cash flow matters most. Jeff Bezos among them. Given free cash flow, a cost of capital price, and a growth rate an analyst could determine the present value of that cash flow and that is the value of the stock.
- What the stock sells for. It is not possible to buy a few shares in a business using pricing mechanism one. I suppose you could buy the whole business on that basis, but for we poor folks who lack the billions needed to do that, we must settle for the market price. That price is determined by an auction. There are buyers and sellers and the buyers bid a price and the sellers present an ask price. When the two coincide there is a trade and that price becomes the market price of the stock. The price has little to do with the underlying value of the business and quite a lot to do with the enthusiasm or the lack thereof of the participants.
The long run real value and market value converge
While business valuation has many variables, their number is not close to the number involved in market prices.
If Joe is suffering a job loss, he will be more willing to sell his GE stock at a lower price. If Betty has just won money in a lottery, she may be willing to pay more to acquire shares in her favourite business.
Neither enthusiasm nor depression lasts forever.
Eventually the market price will tend toward the business value. It will not stay there, but will tend to oscillate around the true number. The direction and size of the oscillation will depend on market sentiment. The feeling of fear or euphoria that results from observed conditions.
That feeling is amplified by commentators in print, television and social media. While all of the commentary is future oriented, none of them have the slightest clue what the market price will be in the near term. Long term is more predictable, but who wants to wait.
Repeat every day, “The future is unknowable”
There are Traders and Investors
Investors relate most closely to business valuations. Their goal is to acquire a business with solid cash flow and the ability to distribute that or grow with it. They rely on markets, industries, innovation, leadership and execution.
Traders relate most closely to market prices. They win when they can guess how the other market participants will relate to news about a given company. The fundamentals are useful for their narrative but are not compelling.
For them every decision is two-part. When to buy and when to sell.
Decisions involve facts, emotions, opinion, and assessment.
The stock price in the market means one thing and the business valuation another.
It could be my training, but I think financial facts are far easier to deal with than is human nature. You cannot separate them entirely, but finance is more predictable. Ideally value plus human nature is important.
You should notice when the market is down and people are generally depressed. They will be offering to sell at prices that make sense against the business valuation. You should buy.
Other times when euphoria is the spirit, you should sell to them.
Understand what stock market prices mean to you and your plan. That helps you be objective.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772