by Aram Durphy
Short-term stock price market movements are inherently irrational and unpredictable. Yet many investors use price movement to predict future prices. Investors make the mistake of basing decisions on chaotic or incomplete data. I like to focus on ascertainable information that shows the most complete picture of an investment to get the best results.
We can see a classic example of the perils of drawing conclusions from incomplete data when we look at investors that trade using only historical price performance for buy and sell decisions. The stock market is an auction. Unlike eBay and foreclosure auctions, however, stock markets price assets based on what a company might be worth in the future: that is future cash flow valued in today’s dollars. In reality, though, many investors pay little attention to a company’s prospects, fundamentals, management team, strategy, or its future cash flow. These investors care about price trends and tend to buy into hot companies or funds and sell those whose price is moving down.
According to Quantitative Analysis of Investor Behavior, April 2012, (a study by the financial research organization Dalbar) the average equity investor had a 3.49% total yearly return over a 20-year period. The S&P 500 index earned an annual return of 7.81% for the same period. The average investor fell well behind the most basic stock benchmark.
Dalbar reported relatively short holding periods for equities: the average equity mutual fund investor held the fund for just 3.29 years. During bear markets, the holding period dropped to 2.5 years. The general principal at work here is that if the investor can find an investment with the right trend lines, he will beat the market. To find the fund that will beat the market, the average investor turns to historical price performance data. He looks for a fund or stock from hot market sectors or that has beaten the market over the past few years. This is a classic error: the investor is mistaking price movement for fundamental strength.
Historical price trends might be used to help value a company or fund once an investor understands the fundamentals. Without understanding the strength or weakness of an investment, however, price doesn’t actually offer useful information. It only tells you what last year’s winners were. The gains investors seek happened already. When a company is hot, and its price has exploded, it is quickly overpriced and overvalued. The investment may not have reached the top yet, but its ceiling is nearer and future growth probability is limited. Generally, hot price trends for an investment would mean that it is a good time to sell. Unfortunately, for most investors this is when they pile into an investment.
I prefer to accept short-term volatility, and focus my investing energy on areas that are actually quite clear and much less volatile. Use price and fundamentals to find excellent value. That means often seeking out investments whose price trends are down. The smart investor looks for this edge by focusing on the long-term, 5 years or more, and investing in businesses that produce real cash flow, show other signs of fundamental strength, and that the market undervalues. If average investors help us get the best price for that future cash flow by selling cool investments and buying hot ones, even better.