Sharing Lessons
THE STOCK MARKET HAS been one of my life’s enduring interests. No, it’s not because I try to pick market-beating investments. I gave up on that nonsense more than three decades ago.
Rather, I’m fascinated by the way we humans engage with this maddening market that promises both riches and peril, and which seems both ruthlessly efficient and utterly nuts. What have I learned from a lifetime of following the stock market? The sad truth is, I find there’s precious little that I can say with any confidence.
Indeed, I remain convinced that the best strategy is to sit patiently with a globally diversified portfolio of index funds—an approach that requires no crystal ball and very little trading. That said, on top of this know-nothing approach, I’ve layered four key ideas about the stock market.
1. Failing to forecast. When I started investing in 1987, grumpy old men would regularly warn that the market was overvalued and that stock investors would soon receive the punishment they so richly deserved. These market “wisemen” would point out that shares were richly valued based on yardsticks like price-to-book value, dividend yield and price-to-earnings multiples.
And yet, as the years rolled by, stocks kept getting more and more expensive, and those who listened to the grumpy old men were the ones who got punished. It eventually dawned on me that investors couldn't divine the market’s future by studying valuation measures, and today I pay them scant attention.
2. Holding steady. Every day, the market tells us what our stocks and funds can be sold for. But for the sake of our own sanity, we need a sense of our holdings’ value that’s separate from the market’s latest declaration.
No, we won’t be able to figure out what our investments are truly worth. Nobody can. But what we can do is constantly remind ourselves that the fundamental value of our stocks and funds fluctuates far less than their market price—a point made by finance professor Robert Shiller more than four decades ago.
To be sure, if we needed to sell, we’d have to accept the current price. But absent that, we should focus on what we own—companies with valuable assets that generate healthy profits and often pay reliable dividends—and we should hold that notion close, especially when pundits, panicked investors and plunging prices try to bully us into believing otherwise.
3. Freaking out. When valuing a stock, analysts often start by estimating the profits that a company will generate in the years ahead, or the cash it’ll return to shareholders through dividends and stock buybacks. These analysts will then apply a discount rate to the figures for later years because $1 of profits or dividends five or 10 years from now isn’t as valuable as $1 today. They’ll then add up this stream of discounted future earnings or future cash payments to shareholders, and that gives them a company’s intrinsic value.
So, what happens to a company’s intrinsic value if it gets hit with a big economic slowdown or a serious business problem that wipes out all profits for, say, the next three years, thus nixing the company’s ability to pay dividends and buy back shares? Remember, we’re talking here about a financial debacle—no corporate profits for three years—and yet, depending on the assumptions used, the company’s intrinsic value might drop less than 10%.
Meanwhile, in a typical bear market, share prices nosedive an average 35%. In other words, when the news turns bleak and investors freak out, share prices tend to fall far more than the decline in intrinsic value would justify. In fact, judging by the size of the typical bear market decline, it seems investors are effectively assuming that the bad news might last for perhaps a dozen years.
Can’t imagine the world’s companies failing to generate any earnings for a dozen years? When the broad market plunges, maybe what we’re seeing is an overreaction—and what we’re getting is a great buying opportunity.
4. Making hay. Where does that leave us? It’s hard to figure out whether stocks are objectively cheap or not, but it seems that share prices tend to overshoot both on the way up and on the way down.
As I’ve argued before, I’m not inclined to lighten up on stocks when the market appears overheated, because there’s no limit to how high share prices might climb. But it’s a different story during declines: Shares can’t lose more than 100% of their value—and, unless the world suffers economic Armageddon, they won’t.
That’s why I invest more in the broad market whenever there’s a steep drop. No, I don’t try to figure out whether stocks are objectively cheap, because I’ve learned market yardsticks can’t tell us where the market is headed next.
Instead, I simply take my cues from the magnitude of the market’s decline, and the bigger it is, the more enthusiastic I am about buying. That might sound naïve. But after decades of investing, buying aggressively during a bear market—coupled with leaning heavily toward stocks and favoring index funds—are the only ways I know to get an edge.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.The post Sharing Lessons appeared first on HumbleDollar.
