As I write this during the third week of October 2008 the world’s equity markets are in the midst of a sharp decline—some are calling it a “melt‐down.” Many mutual funds have fallen over 40% for the year and there seems to be no end in sight.
Warren Buffet says “Investing is simple but not easy” and in today’s market that statement is truer than ever. Investing boiled down to its essential elements is very simple, buy something at one price and sell that thing later at a higher price. Buy low and sell high. But while intellectually investors know what to do—emotionally investors often do the opposite. Studies have shown that investors invest more money when the market is up and take money out of the market when it is down—basically buying high and selling low.
This behavior is puzzling since this is perhaps one of the few areas where consumers get it wrong— where else do we wait for the sale to end before buying? It doesn’t happen. When our local car dealer offers a $2,000 rebate, do we decline the rebate and wait till the offer is over? Of course not. Selling good stocks/mutual funds in the midst of a market decline is akin to rushing to sell real estate now— when home prices are depressed. Some people are forced to sell real estate now—but most do so with dread.
Why do investors get this wrong? I believe it’s due to our instinctual dislike for uncertainty and the strong negative emotional response that comes from that. Negative emotions are strongest when we don’t really understand why something bad is happening to us. And watching the value of your investment account drop 30 to 40% for reasons unknown is likely to cause extreme negative reactions.
The underlying reason for stock market underperformance is not always readily apparent. And trust me, spending 50 to 60 hours a week reading, watching and listening to market commentators does not always produce a good answer. Nobody knows what will happen in the market next week, next month or the next six months. There are no reliable predictors of what the market will do in the short‐term. Even the best‐of‐the‐best investors—not even Warren Buffet or Jim Rogers know what will happen in the short‐termi. This uncertainty about what is happening in the market day‐to‐day intensifies our emotional response—and emotions cause us to do things that normally common sense would tell us not to do.
If we can reduce the mystique of what the stock market is then perhaps we decrease the emotional response to its machinations—and less emotion creates better investor behavior. In the preface to Benjamin Graham’s 4th edition of “The Intelligent Investor” Buffet says, “What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”ii So let’s take a look at what a stock market really is. The bottom line definition of a stock market is where ownership of public corporations trade hands. Public companies are owned by shareholders—if a company has 100 shares of its stock outstanding—or available for the market (called the Float) and you owned 5 of those shares, you would be a 5% owner of the company. Most public companies have millions or even billions of shares of ownership outstanding—Cisco Systems (CSCO), a very large computer hardware company, has around 5.8 Billion shares outstanding. The public (you and I) can buy a part (our share) of Cisco Systems by simply buying some of those outstanding shares. All we need to do is find someone who owns the number of shares we want to buy and make them an offer so they will sell them to us. That is where the Stock Market comes in. Through a stock‐broker you make a bid on the stock and throw it out to the world and if someone who currently owns the number of shares you seek, likes the bid, they will accept it and a sale is made.
That sale price is posted worldwide and instantly becomes the new price for the company stock. For a widely held company like Cisco Systems, this process takes place thousands of times a day. The collective wisdom (or fallacy) of all the traders in the stock set the value of the company. Simply multiply the share price by the number of shares outstanding and you now know the value of the whole company, or its Market Cap (short for Capitalization)—by the way, Cisco would be considered a Large Cap company.
It is the actual change in the price from the opening trade to the closing trade that draws attention. If you already owned shares of Cisco you would be happy if it closed at a higher price, and of course you would be disappointed if it dropped. It matters very little if you bought it for $100 per share or $25 per share—if it drops $1 per share you have lost the same amount of money ($change x number of shares = profit or loss)—so as investors we’re more concerned with the change than the actual price. (To the company it matters a great deal what the share price is since many of the employee’s compensation may be based on the value of their stock.)
To reduce complexity when reporting on the market, the share prices of certain companies are averaged (share weighted) into indexes that formulate the “market numbers” that are reported constantly in the news—i.e., the Dow Jones Industrial Average (DJIA). The DJIA is frequently quoted since it is the most recognizable index‐‐having been around since 1896. Stock brokers and investors worldwide can make a number of assumptions once they know how the DJIA is doing. When someone asks how the market doing, most often the response is what the DJIA is currently doing.
What affects the price of an individual share or stock of a company is strictly the bid and ask price on the giant, worldwide auction referred to simply as the market. The actual reason that investors bid, ask or sell a company up or down is a different matter. Whatever methodology used to arrive at the price they are willing to pay or sell is usually unknown to the rest of the world—but it’s a collective decision made by millions of investors. There are hoards of people called analysts whose sole purpose in life is to determine the best price to buy or sell a company, however; the analyst’s price targets rarely come to be.
Buying a company cheap‐‐at a value‐‐helps insure a profit when the share price rises later—creating a capital gain. Some companies also reward investors with dividend payments—usually paid quarterly. Many long‐term investors purchase dividend paying stocks in an attempt to reap both capital gains on share price appreciation and dividend payments.
Easy stuff right?—buy low, sell high, and for an added bonus buy companies that pay dividends—a great strategy. The trouble is that most people don’t stick with their strategy, they make the decision to buy or sell based on emotion. As a result, those investors who can put aside emotion and look at the price(s) dispassionately can often make serious money. Many people believe—and I am one—that the collective decisions of frenetic speculators often overshoot on the downside and the upside.
Finally, an interesting fact about pricing in the market is that a good or bad deal for a stock can only be clearly discerned in hindsight. So the day‐to‐day buying and selling does what it does, it sets the market price of companies, whether that price is good or bad, can only be determined by looking back over the years. We can only say today that General Electric was too pricey when 26 million shares sold around $36 a share on January 3, 2008, because we now know we can buy the same shares for around $20. Of course, a year from now we might say that $20 per share on October 29, 2008 was ridiculously low—but we won’t know that for some time.
Since we can’t accurately know where the market is going in the short‐term, then‐‐in my mind‐‐the best strategy is only worry about the long‐term direction—which potentially is upiii. And since we know that historically the long‐term direction is up, then we should, consistently buy a group of diversified asset classes throughout our earning lifetime—putting whatever money we do not really need for the next five years into the market—and then simply, let it be. Your investment will potentially grow—at a pretty good clip‐‐regardless of what CNBC says about it today or tomorrow or next week.
If we do that, (invest long‐term and let it be) when the time comes when we are no longer capable or willing to earn enough money to live on—we can potentially use the invested money we have saved and earned in the market to pay the bills, to live life or leave to our heirs.
In the long‐term, companies and corporations make money—they generate profits—that is just how capitalism and free markets work. If we recognize that emotional and panic stricken investors overreact to changes in the market and we know that long‐term we will make money, then how our investment did last week or last month is fairly irrelevant—more important then is what it’s going to do ten, fifteen or twenty years from today.
Marty Knight, MBA, is a retired Captain from the Maryland State Police and is a Financial Advisor with Chesapeake Investment Advisors, Inc. Chestertown Maryland; he can be reached at 410‐810‐0735 or 1‐ 800‐994‐0221 or email mknight@chesadvisors.com. Written October 30, 2008
Diversification does not ensure a profit or protect against loss in a declining market. Securities and Advisory Services offered through Geneos Wealth Management, Inc. member FINRA/SIPC
i Jim Rogers, Billionaire investor and Author of Adventure Capitalist, Investment Biker and Hot Commodities calls himself “The world’s worst market timer.” Warren Buffett in an October 17, 2008 opinion piece in the New York Times says, “I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now.
ii Buffett, Warren, “Preface to the Fourth Edition, by Warren Buffet: Graham, Benjamin: The Intelligent Investor, 1973 HarperCollins Publishers, New York, NY,
iii For a good website on Compound Annual Growth Rate seehttp://www.moneychimp.com/features/market_cagr.htm
