Price vs. Value

YOU CAN THINK OF INVESTING as a battle between two often-competing pieces of information: What you think an investment is worth—and what the market thinks. If the gap between the two gets too far out of whack, there’s a danger that investors will behave foolishly.

While it’s easy to figure out what, say, a certificate of deposit or a Treasury note is worth, it’s much harder to put a value on stocks, gold, high-yield junk bonds and other riskier investments. Even most money managers, who devote their professional lives to scouring the markets, aren’t skilled enough at spotting undervalued investments to overcome the investment costs they incur and the management fees they charge, and thereby deliver market-beating returns.

That’s why I start by assuming that the current price for stocks, bonds and other securities is probably pretty close to the fundamental value for these investments. I don’t subscribe to the extreme version of the efficient market hypothesis, which says securities are always correctly priced. But I do believe that the market is sufficiently efficient that it’s extraordinarily hard for investors to earn market-beating returns over the long run, and thus most of us should steer clear of picking individual stocks and buying actively managed funds.

This conflating of price and value, however, has its dangers. It’s a scenario you see often: Folks buy an investment that they think is good value, but then they’re thrown into doubt by falling prices and some end up selling at the worst possible time.

This danger looms especially large during major market declines. Cast your mind back to March 2009, when the S&P 500 was 57% below its October 2007 high. If you had bought a collection of stocks for $1,000, and now honestly believed that their true value was just $430, dumping your holdings wouldn’t be an unreasonable response. After all, given that extraordinary loss of value in just 18 months, who knows what your shares might be worth if you stuck with them for another few months?

But selling in March 2009 would, of course, have been a terrible mistake—which is why we need a sense of stocks’ value that is distinct from their price. That brings us back to the distinction between the market’s investment return and its speculative return, which I wrote about a few weeks ago. With any luck, if you have a handle on the long-run investment return you’re likely to enjoy, thanks to dividend payments and earnings growth, maybe you’ll get less rattled when the market’s short-run speculative return goes against you—and you might even view it as a buying opportunity.