Tuesday, 23 August 2011

Stock Market Returns - Majority Rules

One of the first practical things you learn as a financial adviser is that you have absolutely no control over "the market."

"The market" is a backward looking measure of valuations and in that sense, the market never actually "does" anything. You may hear on the news that "The market has done well" or more likely at present that it has done really badly but in reality it has done nothing...

We on the other hand, as investors have done everything. Every transaction has a buyer and a seller and as such they agree on a price for the stock. As individuals we simply make our decisions based on the news we hear, news I might add that everybody else has heard as well.

So this is where sentiment comes into play. Everyone, especially retail investors would be wise to understand the role sentiment plays in the determining the short term value of stocks. THE MARKET WILL 'DO' ONLY WHAT THE MAJORITY OF PEOPLE THINK IT WILL DO!

If the majority of traders feel a stock is going to take a tumble they will try to sell their holding. Basic supply and demand forces dictate that while supply (people trying to sell) outstrips demand (people willing to buy) a stock price will fall...

As the stock price falls it becomes more and more attractive. At the tipping point the majority of traders will switch from being sellers to buyers. The price will start to rise as more and more people try to get hold of the stock (demand outstrips supply). This is why a dramatic fall in the price of a stock is very often followed by a very steep rise; with some 'lucky' traders profiting from the stock price volatility...

Despite how it feels at the minute the majority of stock prices are usually relatively stable. The short term stock price really reflects only what the majority of people think that stock is worth rather than the actual value of the company...

As the stock price rarely accurately reflects the underlying value of a business it is a dangerous game to try and "play the market." Traders can react to news very quickly which is how we see dramatic alterations to stock prices. A retail investor, without having all the news available to the market and then having the ability to react correctly to and with the majority of other people is more than likely going to make the wrong decisions...

Retail investors are rarely in a position to react to news quickly enough to protect themselves from short term volatility. In the week or so it takes to sell or transfer an ISA investment for example "the market" will no doubt have moved on, it's possible that the retail investor will be selling at just the point where the majority of traders are starting to buy again.

Instead of playing the short term game, which is very difficult if not impossible, the vast majority of people need to avoid the sentiment driven market reactions and instead opt for a long term strategy. If the majority of traders swing from buy buy buy to sell sell sell the likelihood is at some point they / you are going to get it wrong. If you take a step back and understand that the real value in the UK stock market is in the dividends and long term solid understandable company growth then all the bluster about short term prices should be less of a worry for you.

Companies tend to grow, that is what capitalism is about, so in the longer term you will receive a much happier investment experience if you understand that short term sentiment rarely effects long term profitability, only short term volatility.

So in my humble opinion the way to achieve the most successful investment experience is to avoid getting caught up in the sentiment driven reactions to short term media driven news, maintain a long term strategy that you stick to not just when things are on the up and try not to panic when all around seems to be negative and suggesting you should start to sell... By the time you have got that news it is already too late, just ride it through.

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