Sunday, 22 January 2012

My occasional rumination

Comprehending the Thinking Driving the Behaviour in Investing

One of the most fascinating figure in investing is the wide range of intrinsic value one can obtain from various types of valuations and by various analysts.

It is this inability to determine the intrinsic value or the lack of consensus of what constitutes the right intrinsic value that allows the price of the stock to zig-zag but always tracking the intrinsic value.  Over the short term, the price may be up or down by a wide margin.  However, over the long term, it always reflect the fundamental value of the business.

Are you a bargain hunter? Are you a trend follower?  There are more than one way to make a profit from the stock market.  There are also more than one way to make a loss from the stock market.  The rules are generally fair, though one need to watch out for manipulations in certain price movements of certain stocks.

There are those who discard the fundamentals and only study and follow the sentiment driving the supply and demand of the stock.  Buy low and sell high.  Buy high and sell higher.  It sounds so easy for an "expert" to pronounce that those who did not do this on the first trading day of this month by following the chart would have been stupid or foolish, given the chart patterns.  To these believers, fundamentals do not matter in their trades.

On the other hand, there are those who discard the charts.  They painstakingly study the fundamentals.  They patiently analyse their thinking and behaviour guiding their investing.  They are generally followers of value investing as practised by Benjamin Graham and his students.  They track a few high quality stocks and bargain hunt when the price is right.  They have strict rules too guiding their selling.  Their achievements are not measured by the days, weeks or months, but over a long period of years.  After an initial period of investing, their returns are often positive by a huge percentage over their initial cost.  Short term fluctuating prices in the stocks of their portfolio rarely cause a capital loss in their portfolio value.  The low markets significantly reduced the compound annual growth rate returns for the whole investment when these were measured at those times.  On the other hand, the compound annual growth rate rebounded when the returns were calculated at the time when the market shot up to stratosphere.

Those who trade protects their downside with stop loss strategy.  They often take profit when a certain percentage gain is achieved.  They may also allow the winners to climb higher at the same time moving their stop loss value higher.

Those who employ value investing, protect the downside through buying with a margin of safety and careful stock picking.  They often allow these stocks to eventually reflect the fundamental intrinsic value.  Often the carefully chosen stock can be held for long term, without the necessity to take short term profit.  Compounding over years provide the substantial returns.  The reinvested dividend returns contitute a substantial part of the return too, this return is not enjoyed by the chartists whose investing period are often short term..

While the traders may plough in a certain amount onto a certain stock, to make big gains over a short trading period, this amount has to be meaningful and substantial.  Short term volatilities are unpredicatable and this constitutes the main risk in trading.

On the other hand, those who value invest can usually afford to keep a large amount in their portfolio permanently.  This is safe except druing those times when the market is truly bubbly.  The volatilities in the market over the short term do not affect their investment behaviour which is strategized for the long term.  The short term volatility is often treated as a "friend" when the price can be taken advantaged of.  Over the long term, these short term volatilities - often a tinyl blip on the long term price chart - is in fact very small for carefully chosen good quality stocks.

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