The world is oversupplied with oil, U.S. interest rates are rising and international prospects look dim, with slowing growth in China and persistent troubles in Europe and Japan. How should investors react?
When asset prices decline, people naturally want to take action to alleviate the pain. Yet sometimes no action is the best reaction. Trying to avoid the next market meltdown or identify the next hot market is a siren song for all investors, but even professional investors are collectively unsuccessful when they try to time buying into or selling out of particular investments. For the 15 years ending December 31, 2014, only 19 percent of stock mutual funds and 8 percent of bond mutual funds survived and outperformed their indexes, according to data from Dimensional Fund Advisors and the Center for Research in Security Prices at the University of Chicago.
Knowing a bit more about how the markets work can help you understand why maintaining a consistent, diversified approach to investing is the right philosophy for achieving long-term success, regardless of the crisis du jour.
Understanding Valuation Principles
The basic theory behind investing is easy to understand: Buy low; sell high. However, determining what an investment is worth, and thus which investments are underpriced and which are overpriced, is not as easy as it seems.
U.S. Treasury Regulations define “fair market value” for federal tax purposes as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Essentially, this describes what happens in the stock market every day. Two independent parties reach a mutually agreed-upon price at which to trade an investment.
This definition also encapsulates one of the theories of valuation: An investment is worth only as much as someone else is willing to pay for it. If people are enamored with tulip bulbs, Beanie Babies, tech stocks, real estate or gold, they might pay ever-higher prices that seem to have little rationale. The buyers of a seemingly overpriced asset might just be hoping they find a greater fool who will buy it from them at an even more inflated price. The possibility that they are, in fact, that greater fool scares many investors.
On the other hand, there is another theory of valuation that says each investment has an intrinsic value, which can be determined through due diligence. Most investors consider this intrinsic value when they try to price an investment based on the current value of its future cash flow. However, this second method is not as robust as it sounds, because it still relies on the investor’s assumptions. The future cash flow of most investments is not certain, regardless of how much research an investor performs. As a result of this uncertainty, any valuation can be justified based on a given prediction, though thoughtful analysis should still result in a more accurate assessment of intrinsic value.
Each investor makes certain assumptions about the future and has reasons to buy or sell an investment. Every time a trade occurs, it is another affirmation that two parties agreed on an appropriate fair market value for the investment at that time. In this way, the market incorporates the collective wisdom of all investors’ different predictions of the future.
The degree to which a market’s prices are accurate and its mispricings are unpredictable is known as a market’s efficiency. Efficiency varies by markets. Markets with more participants, a freer flow of information, better-informed participants and more trading tend to be more efficient than markets that lack these features.
But markets are not perfect, and mispricings occur from time to time as a result of many investors either choosing to ignore intrinsic value or incorporating incorrect assumptions in their fundamental analysis. These mispricings tend to be random in efficient markets, and it is hard to know when your viewpoint is smarter than the collective wisdom of the market. You should only attempt to outperform an index if you believe that you, or someone you hire, can secure a sustainable advantage versus other market participants.
Avoiding The Temptation To Time The Market
Many of us think we are smarter than the average investor, so we should be able to outperform the market. We read headlines about the hedge fund manager or other star investor who profited handsomely by accurately predicting the last unexpected event. The next time you hear about these predictions, remember this quotation from Malcolm Gladwell: “If you make a great number of predictions, the ones that were wrong will soon be forgotten, and the ones that turn out to be true will make you famous.”
One investor may get several predictions wrong before getting one right and may be too early with his or her prediction. In hindsight, we will recognize such clairvoyance, but before the unexpected occurs, multiple experts would likely predict wholly different scenarios. The majority of professional investors underperform the market, and those who consistently outperform may do so by chance.
While experts who have a contrarian viewpoint that is ahead of the market might outperform the market as a whole, individual investors will have a much more difficult time succeeding. If you expect a recession based on something you read in The Wall Street Journal or heard on CNN, it is likely pointless to trade on that information, because that possibility is already incorporated into the current market price of investments. Similarly, if you read a story about a company’s breakthrough product, it is also too late to buy that stock. Trading based on your own theories should only result in excess profits if your viewpoints are more accurate than the market’s view as a whole.
If I expect gas prices to go up next week, I will fill my tank today, even if I have plenty of gas. If I expect prices to go down, I’ll roll into the gas station on fumes next week. Markets work the same way to incorporate people’s expectations of the future.
If a region, sector or company is likely to produce higher output in the future, the stock market often takes notice of this and prices the expectation into the current valuation. The stocks go up, even though the good news or growth has not yet arrived. So if investors already anticipate substantial growth in a country, that market’s future returns might not exceed those of a slower-growing economy, since the faster growth was already accounted for in the original market price. An investment is most likely to outperform when its prospects or earnings exceed the market’s expectations.
Under these circumstances, growing a portfolio is not as easy as identifying the market with the highest potential for growth in future output, and investing accordingly. One of the biggest mistakes investors make is trying to trade based on a very accurate prediction for which the market has already accounted.
Investors can get a little more information about how expensive a company or market is by looking beyond recent stock market movements. Just because markets have declined does not mean their value cannot fall further. Nothing in the laws of math or the markets prevents an investment that has fallen 50 percent from declining another 90 percent. For this reason, you should not concentrate your portfolio in an area that has had recent trouble with the hope of it bouncing back.
Experienced investors often look at certain valuation metrics to give them an idea of how expensive an investment is. The most widely known of these measures is a stock’s price-to-earnings ratio, but there are several others, including its price-to-book value, price to cash flow and dividend yield. These measures provide more information than just looking at a market’s recent moves, and they can be compared across time and across markets to determine a market’s relative valuation. However, again investors as a whole might be correct to seemingly over- or underprice a market, and it is hard to know when the market is wrong.
You can find substantial support to prove that almost any valuation is right, and probably just as much to prove that it is wrong. Cheap markets can get cheaper, and frothy markets can get more expensive.