Intelligent Investor Chapter 8 Summary: The Investor and Market Fluctuations

The Investor and Market Fluctuations

  • Bonds of short term maturity(~7 years) won't be affected so much by market fluctuations, but long term bonds will be affected and common stock is certain to fluctuate.

Market fluctuations as a guide to investment decisions:

  • As even stocks of investment grade fluctuate, investor would want to benefit from the swings by - timing(anticipating market) and pricing(buying when quoted below their fair value and selling when they raise above it).  Less ambitious form of pricing is not paying too much for stocks when you buy them.
  • Emphasis on timing will probably transform him into speculator. Timing is important for him as he wants to make profits in a hurry.
  • We are always persuaded to form some opinion about prices. Public tends to follow forecasts as they think that experts are more dependable than themselves. What they fail to realize most of the times is that when everyone follows the same publicized forecast, who will play the counterpart of the forecast?
  • For investor, timing is of no value unless it coincides with pricing.
  • Dow theory on timing was popular - when a stock is bought if it breakthroughs a threshold and is sold on similar breakthrough on the downside. But as this formula gained adherents, it stopped working. With time, new conditions arise which the old formulas don't consider and with many followers, returns diminish as a stampede ensues.

Buy Low, Sell High:

  • Remember that a decline of 50% fully offsets a preceding advance of 100%.
  • Bull market characterized by -high price, high P/E, low dividend yield compared to bond yields, speculation on margin, new issues of poor quality. But it's difficult to determine when a cycle has started and ended. It may happen that the investor waits indefinitely for the prices to fall and only then buy - he may miss the market cycle and end up as a spectator.
  • Better to change proportions of stocks to bonds instead- tactical asset allocation.

Formula Plans:

All things excellent are as difficult as they are rare.
  • Essence of all formula plans is to sell some stocks when market advances substantially. But this like other formulas stopped working as it grew popular. Also, people may have earned profits, but they were out of market as all their stocks ended up being sold and they couldn't buy anymore.
  • Any plan/formula that is easily described and followed by a lot of people is too simple and easy to last. Their effects reverse over time and regress to mean.

Market Fluctuations of the Investor Portfolio:

  • Second line companies fluctuate more compared to primary companies. But this is not to say that they will perform poorly.
  • Graham says that your stock may increase by 50% and drop by 1/3rd of the new price - which basically means you may end up where you started.(10-->15-->10).
  • It's advised to keep yourself away from following the crowd. But as human psychology makes you restless, re-balancing your portfolio is suggested as an outlet for your pent up energies and emotions.

Business valuations vs Stock market valuations:

  • Two ways to look at share holders- 1)Minority shareholder/silent partner in private business whose results depend on the profits of company or a change in underlying value, calculates his share of net worth from recent balance sheet 2) Holder of a electronic blip whose price fluctuates every moment and is very different from the balance sheet value.
  • We depend too much on daily quotes and the share prices are well above their net asset value.
  • A paradox: The better a company's prospects are, the more the price differs from it's net asset value. This makes the price fluctuate as per the moods and swings of the market. So a better performing company with a quality stock will have more speculative factor. This happened with IBM and Xerox, whose losses indicate a lack of confidence not in the company's growth, but in the valuation of stock market.
  • Price<1/3(NAV) is good. But just this factor doesn't make any stock favorable - good earnings to price ratio, strong financial position and prospect that earnings will be maintained in future years all need to be considered.
  • A & P is the best example to illustrate the effects of valuations, whose price was undervalued despite the company's earnings owing to factors like tax on chain-stores, a decline in net profits compared to previous year and a general decline in market. So these stocks were available at bargain prices. Later, the company gained substantially and it's price shot up surprising everyone. But this began a phase of overvaluation as speculation grew, prices collapsed and A&P reported quarterly deficit finally.
  • Critics of value approach say that quotes provide the benefit of liquidity- investor has the benefit of daily appraisal and option to increase or decrease his investment as he chooses.
  • Know important price movements to base you judgement on. But don't act on market unless you agree with it based on the value of you holdings from full reports of the company. Quotes may give warning signals to investor, but often these are misleading.

Summary:

  • Speculator's primary interest is in anticipating and profiting from market fluctuations. Investor's primary interest is in acquiring and holding suitable securities at suitable prices. Market movements are important in a practical sense to investor as they create low prices to buy and high price to refrain from buying and sell if he chooses to.
  • Long wait for prices to fall is not profitable, instead you may chose to buy when you have money except when market is too high. Look out for the ever present bargain issues. 
  • Stay away from any activities that emphasize price movements first and underlying values second.
  • Market quotes are just for convenience - don't buy because it has gone up or sell because it has gone down.
  • Good management of a company never lets the quotes impact the price permanently in a poor way. Pay attention to managerial competence.

Fluctuations in Bond Prices:

The more it changes, the more it's the same thing.
  • Long term bonds price changes in response to interest rate variations. Yield moves inversely with bond price, though not in same proportions. So buying a bond because it's price has gone high is not wise, as it incurs very low returns.
  • Earlier, bonds can be studied to find a clue about the coming end of bull/bear market. But now no such similar clues are available. Bonds are completely impossible to predict. So invest based on your preferences.
  • A better approach is using amortized cost which disregards market prices.
  • Convertible bonds and preferred stock fluctuate because of fluctuations in related common stock, credit standing of the company, general interest rates.
  • Compromise between complete stability of principal with varying interest rates and fixed interest income with variations in principal - neither interest nor principal fall below a stated minimum over 20 years. This happens in bond contracts(TIPS).
  • Poor quality preferred stocks fluctuate widely.

Commentary:

The happiness of those who want to be popular depends on others; the happiness of those who seek pleasure fluctuates with moods outside their control; but the happiness of the wise grows out of their own free acts.

  • Most of the times because of all the haggling of buyers and sellers, the valuation is done good enough on average and the pricing may be accurate. But sometimes, price is not accurate and even wrong.
  • Market manic depressive - gets too enthusiastic as prices rise and buys, gets too depressive as prices fall and sells. Best example is Inktomi which was selling at 250 times the company's revenues and later at 0.35 times it's revenues - making it a good bargain deal for Yahoo.
  • Do business with market only when it suits your interests. Market's job is just to provide you with prices, your job is to decide how to act on it.
  • The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.
  • The pros can't even win their own game. Money manager's are handicapped by these:
    • Huge amounts handled by them need to be invested in biggest stocks, making many funds owning same few overpriced giants.
    • As investors pour more money into funds, they buy more of the same stocks they already own shooting up the prices to dangerous highs.
    • When investors ask their money back when market drops, they are forced to sell shares making the stocks cheap.
    • To get bonuses for beating the market, any new company added to index is bought.
    • Specialization in one thing makes them sell other kind of stocks even if they love it.
  • Control the controllable - brokerage costs by not trading too often, ownership costs by not buying funds with high fees, expectations, risk by proper asset allocation, diversification and re-balancing, tax bills by investing long term and behavior.
  • If your investment horizon is long -25 to 30 years- buy every month automatically and whenever you can spare money - a total stock market index fund. Sell only when cash is needed for health emergencies, house down paymnet, loss of job etc.
  • Selling into bear market is sensible if your losses can be subsidized by taxes.
~

See Intelligent Investor Summary for other chapters summary.


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