The market is a giant mass of people all trying to guess what’s going to happen next. Because of that investors set an expectation for the future of a company or the market based on past results and how they feel that day.
There’s just one slight problem. Even if you guess the expectations right, there’s no guarantee the market will agree with you. You have to guess the price right too. Ben Graham explained that problem in the lectures I referenced last week.
That’s why patience and discipline are so important in investing. But once you understand market psychology and its tendency to fluctuate, you can start to use that to your advantage.
The only caution we would want to add to that is this: If by any chance you are still going through the usual alternations of bull markets and bear markets, — which is by no means unlikely — then there is no particular reason to believe that when the market has receded to about its average value it would necessarily have stopped going down. Experience in former markets indicates that just as they are too high in bull markets, they get too low in bear markets. If we are going through a similar experience now, the historical analogies would point to lower prices, simply because in bear markets securities sell for less than they are worth, just as they sell for more than they are worth in bull markets. Whether that means that a person should avoid a bargain security because he thinks the general market is going down still further is quite another question; and I think that is largely a personal matter. Our opinion is that for the investor it is better to have his money invested than it is to feel around for the bottom of the securities market. And if you can invest your money under fair conditions, in fact under attractive specific conditions, I think one certainly should do so even if the market should go down further and even if the securities you buy may also go down after you buy them.
Of course, buying stocks on the way down is not the easiest thing for most investors to do. If it were easy, then everyone would do it, but then the market wouldn’t act the way it does.
This is one of the paradoxes of investing. Most people understand that buying something at an attractive price is a good idea but they have a hard time following through on it when it comes to stocks. They either try to time the bottom (and miss), they treat the market like a popularity contest (falling prices are unpopular), or they’re too busy trying to protect the falling balance in their account (selling to protect what’s left).
Graham’s only rationale around this is to stop treating stocks like pieces of paper.
You don’t get very far in Wall Street with the simple, convenient conclusion that a given level of prices is not too high. It may be that a great deal of water will have to go over the dam before a conclusion of that kind works itself out in terms of satisfactory experience. That is why in this course we have tried to emphasize as much as possible the obtaining of specific insurance against adverse developments by trying to buy securities that are not only not too high but that, on the basis of analysis, appear to be very much too low. If you do that, you always have the right to say to yourself that you are out of the security market, and you are an owner of part of a company on attractive terms. It is a great advantage to be able to put yourself in that psychological frame of mind when the market is not going the way you would like.
The same can be said for mutual funds. Owning a basket of businesses with real earnings (not paper) is easier to rationalize holding on to when the market doesn’t agree with you.
The important thing to remember is that price matters. So even if you can’t buy stocks in a falling market, paying a fair price is still okay. Missing the opportunity to buy at a lower price happens all the time. But don’t try to make up for it by paying a too high price later on.
The first division, you recall, was the simple identification of good companies and good stock; and one is inclined to be rather patronizing about a job as easy and elementary as that. My experience leads me to another conclusion. I think that it is the most useful of the three conventional approaches; provided only that a conscientious effort is made to be sure that the “good stock” is not selling above the range of conservative value.
Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.
Your money is better off in cash or bonds. This gives you optionality should prices fall and diversification from market risk. If you understand that markets fluctuate, eventually another opportunity will present itself.
Now he can also follow a mechanical system of operating in the market, if he wishes, like the Yale University method that many of you are familiar with. In this you sell a certain percentage of your stocks as they go up, or you convert a certain percentage of your bonds into stocks as they go down, from some median or average level.
I am sure that those policies are good policies, and they stand up in the light of experience. Of course, there is one very serious objection to them and that is that “it is a long time between drinks” in many cases. You have to wait too long for recurrent opportunities. You get tired and restless — especially if you are an analyst on a payroll, for it is pretty hard to justify drawing your salary just by waiting for recurrent low markets to come around. And so obviously you want to do something else besides that.
The thing that you would naturally be led into, if you are value-minded, would be the purchase of individual securities that are undervalued at all stages of the security market. That can be done successfully, and should be done — with one proviso, which is that it is not wise to buy undervalued securities when the general market seems very high. That is a particularly difficult point to get across: For superficially it would seem that a high market is just the time to buy the undervalued securities, because their undervaluation seems most apparent then… If the general market is very high and is going to have a serious decline, then your purchase…is not going to make you very happy or prosperous for the time being. In all probability the stock will also decline sharply in price in a break. Don’t forget that if…company sells at less than your idea of value, it sells so because it is not popular; and it is not going to get more popular during periods when the market as a whole is declining considerably. Its popularity tends to decrease along with the popularity of stocks generally.
If you are pretty sure that the market is too high, it is a better policy to keep your money in cash or Government bonds than it is to put it in bargain stocks. However, at other times — and that is most of the time, of course — the field of undervalued securities is profitable and suitable for analysts’ activities.
The reality is: investing is hard. Even with patience and discipline, an expensive bull market can drag on longer than most people are willing to wait. It doesn’t help that the market is full of distraction. A mechanical system, like Graham mentioned, has the added bonus of keeping you busy while you wait.
The important point is to beware of buying popular stocks when the market is at the height of popularity, but also beware of “cheap” stocks because loved markets eventually turn into loathed markets that drag everything down with it. For the “value-minded” investor, loathed markets are worth buying.