The market prices reflect the sentiment of the investors. To protect oneself from the volatilities of the market prices, the smart investor needs to understand the value of the business he is investing into.

It is the nature of the market that prices of a stock can be pushed to very low level when the crowd is pessimistic.  On the other hand, the prices of these same stock can be pushed to very high level when the crowd is optimistic.  The reasons maybe fundamental or sentimental.

The market prices reflect thus the sentiment of the investors.  However, the value of a stock is unlikely to change very much during these short periods when the market prices may change drastically.

To protect oneself from the volatilities of the market prices, the smart investor needs to understand the value of the business he is investing into.

More investors lose money when they overpay for the stocks when the crowd is overoptimistic.  Many hold onto losses in unbelievable denial.  This is evident whenever the price of a stock falls.  Why does the price of a stock fall?  Often these investors blame many external factors for the fall, when in fact, the single most important reason is themselves, they overpaid for the stock during period of over-optimism.

Price is not value, pricing is not valuation, and pricing models are not valuation models.

A valuation model is an effective method for estimating economic value.


Another term that is used to refer to economic value is "fundamental value", which derives the quantity of value from so-called fundamental economic metrics generated by a firm at the firm-level, in contrast to pricing metrics generated by a securities market at the security-level. 


Price is not value, pricing is not valuation, and pricing models are not valuation models. 


The conventional academic capital asset pricing model has one factor, the beta coefficient. 

• Models that include beta are pricing models, not valuation models. 
• This is not merely a matter of semantics. 

The difference between price and value, referred to as the margin of safety, is the raison d'etre of investment valuation independent of market pricing.


http://www.numeraire.com/value.htm

Risk is dependent on both the nature of investments and on their market price

The risk of an investment is described by both the probability and the potential amount of loss.

The risk of an investment - the probability of an adverse outcome - is partly inherent in its very nature.

• A dollar spent on biotechnology is a riskier investment than a dollar used to purchase utility equipment.  
• The former has both a greater probability of loss and a greater percentage of the investment at stake.

In the financial markets, however, the connection between a marketable security and the underlying business is not as clearcut.

• For investors in a marketable security the gain and loss associated with the various outcomes is not totally inherent in the underlying business; 
• it also depends on the price paid, which is established by the marketplace.

Greater risk does not guarantee greater return, risk erodes return by causing losses.

Greater risk does not guarantee greater return.

To the contrary, risk erodes return by causing losses.

It is only when investors shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.

By itself risk does not create incremental return, only price can accomplish that.

Handling stock price falls

• 30 May 03

When a stock price falls, do you sell, buy more or hold on? It all depends, but there are some techniques to help you with your thinking, and your emotions.

One of the questions we're frequently asked is how to handle a tumbling stock price. Should you cut your losses, buy more or sit on your hands nervously and do nothing?

Unfortunately, the Zen art of value investing doesn't lend itself particularly well to never-fail formulas, so absolute answers are impossible. There are, however, some basic principles that you can look to for guidance.

First of all, you should be looking to sell (or not buy) shares that look expensive and aiming to buy shares that look cheap. The direction in which a share price has recently travelled is not in itself an indicator of this.

When to hold

Secondly, too much trading will just hand the returns from your portfolio over to your broker. That means that there's usually a large grey area between buy and sell where you should be happy simply to hold.

Finally, you should always maintain a sensibly diversified portfolio so that your fortunes are not too closely tied to a few holdings.

If a share falls and you keep adding large chunks, then it might end up accounting for too much of your portfolio. That's not a happy situation even if you think it's the cheapest share on the market.

It's worth noting that all of this has just as much relevance if a stock in your portfolio has gone up in price, or even if it hasn't moved at all. What matters is the relationship between the price and the underlying value, subject to diversification and keeping your trading costs down. Putting this all together, we can get an idea of what to do in certain situations.

If a share has fallen by, say, 20%, but you estimate that its underlying value has fallen by less, or indeed grown, then generally we believe it makes more sense to at least consider buying more (subject to keeping sensibly diversified).

An example of this would be Macquarie Bank (see page 4), which we've consistently seen as being undervalued. As its price fell from above $30 last year, we continued to recommend buying and it became a strong buy in issue 114/Oct 02 (Strong Buy up to $21 - $20.39). The shares have now recovered to $27.70.

Time to sell

If a share has fallen by a certain amount but you estimate that its underlying value has fallen by more, then you certainly shouldn't be buying more. That would just compound the original mistake. Instead, you'd want to face up to the mistake and think about selling.

If a share has fallen and you estimate that its underlying value has fallen by a similar amount, then you'd sit on your hands and do nothing.

To avoid too much expensive trading, this should probably be your starting point. To either buy more or sell, your views should be very strongly held.

Our recommendations on AMP are an example of the sell and hold situations. At the beginning of last year, with its share price up near the $20 mark, we had it as a hold. But we were unimpressed by its results in March 2002 noting, in particular, that its 'international or bust attitude' was cause for concern.

So we downgraded it to sell in issue 98/Mar 02 (Sell/Switch to Suncorp - $19.12) and continued to recommend selling as the price fell (and as its underlying value evaporated).

We finally reverted to a hold in issue 113/Oct 02 (Hold while Unstable - $11.78), because we considered that the fall in the share price had finally caught up with the deterioration in the underlying value of the stock.

Since then, we've felt that the falling share price has been matched by a fall in business value (such as we're able to judge it) and have continued with the Hold while Unstable recommendation.

Different thinking

It can sometimes help to imagine that you don't actually own your downtrodden shareholding, but instead have its value in cash. If that was the case, would you use the cash to buy those shares at the current price or invest in something else?

If you find you get a definite no, then it might be time to sell. If you get a definite yes, then you'd think of buying more.

If you get a maybe, then you're probably in the area where the transaction and tax costs of taking any action would outweigh any potential benefits. In this case, it's usually best to to sit on your hands and hold on to your shares.

It's never easy to deal with a falling share price and there are no clear-cut rules to follow. But this approach, used advisedly, can be a useful way of addressing the issue. We hope it helps.

http://www.intelligentinvestor.com.au/articles/128/Handling-stock-price-falls-.cfm

Quick Rules for Recognizing Value and Un-Value

This summarizes how to use PE and its "family of measures to recognize value and un-value in stocks and stock prices.

Many of these can be found in common stock screeners, so it's possible to use these factors not only for final valuation but also for stock selection.


Value

First, find sound and improving business fundamentals - improving ROE drivers and intangibles. Then:

Earnings yield > bond yield (now or soon, some compensation for equity risk)

PEG 2 or less (growth at a reasonable price)

Stock price growth potential exceeds hurdle rate (e.g. 15%, 10 years, probably better than most other investments)

P/S less than 3 and profit margin greater than 10% (good profitability at reasonable price)

P/B less than 5 and ROE greater than 15% (good overall returns at reasonable price)

Shares of companies that fit the preceding factors (the more factors, the better) are more likely to be a good value for the price.

Un-value

Earnings yield < bond yield with low growth prospects

PEG greater than 3 with low margins

Stock price growth falls short of hurdle rate (e.g., 15%)

P/S greater than 3 with low margins

P/B greater than 5 with low ROE