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 digitalmarketingwar wisdom of all investors’ different predictions of the future.