Presently, market fluctuations are an ever-present source of anxiety for both current investors, and potential investors considering risking their savings for potential returns. Before being able to conquer the fear of fluctuations in your investments, it is important to understand precisely what is happening when the markets move up or down, as well as the distinct difference between an investor and a speculator.
If for example the entirety of your investments are placed in high-grade bonds with very short maturity (perhaps 5 years or less), market fluctuations should not and most likely will not be on the top of your list of concerns. Such an investment strategy likely relies on simply receiving your fixed interest coupon payments, and then the invested principal back at the maturity date. However, venturing into long-dated bonds will certainly open you up to the real and significant impact of price fluctuations. In addition, any allocation to common stock in your portfolio, no matter how large and respectable the company, is sure to bring with it unexpected ups and downs in fair-market valuations over time. As attitudes toward the broad-based economy change, interest rates shift, profitability of the specific company diverges from expectations, or any variation of geopolitical event occurs, the market will respond; driving the publicly traded and agreed upon price of any security higher or lower than whatever you happened to pay for it in the past.
As is evidenced throughout history, the market’s perception of securities as a whole, a particular sector or asset class, and even one specific company, can through emotion and momentum be thrown far out of sync with rational fair valuation metrics. This can and will of course play to your advantage or disadvantage across time as a long-term market participant. Any investor should be prepared for these possibilities from both a financial perspective, as well as a psychological one.
One of the greatest challenges as an investor is in fact having to resist the temptation to try and reign in and become a master of market fluctuations. This is where one can potentially begin to step into the realm of the market speculator. However, before casting aside all shrewd market analysis and investment decision-making as folly, it is imperative to separate this analysis into two distinct categories; one of pricing and one of timing. Starting with the prime example of market speculation, timing decisions are based on the belief that one can reliably and on average predict the future swings in market movements or imbalances, whether they be up or down. It should come as no surprise that this is the investment strategy that both simultaneously has the most devout believers and the least success stories; as the large market pendulum swings are by definition those which seem irrational and are unpredictable. In other words, if they were easily understood and predictable, the environment capable of producing the large movements would never manifest itself in the first place. This is just one of the reasons why the most seasoned investment professionals concur that timing the market is in most cases a fool’s errand.
This should stand in stark contrast however to the other methods of market analysis and investment decision making, which are those based on pricing. Pricing decisions, simply put, are those that lead you to purchase an investment whenever the quoted price happens to be lower than whatever you determine to be its fair value. Fair value can be determined in any number of ways, with one of the most fundamental and basic approaches being the dividend growth model; or in other words, how much you are willing to pay for the rights to the future income stream of dividends granted to you by being a common stock shareholder. Pricing decisions assume no special knowledge of future market movements. In fact, it is not uncommon to make a “correct” pricing decision, and then see the quoted market price go down. In this scenario the shrewd investor would simply buy more of the further “discounted” stock. In most cases, investment decisions based on this pricing methodology are likely to buy and hold indefinitely, selling only if in the future the quoted market price happens to be significantly higher than the determined fair value. This sell decision again assumes no unique insight granting windfall profits from guessing where the market will move in the future; and the investor will at times witness missing out on positive returns via continued price appreciation post-sale. However, in the long run the most consistently successful investment strategies focus on understanding what you are buying, understanding the real value of the security, and making purchase decisions especially when the market price happens to be beneath its fair value.
A defining characteristic between the speculator and an investor lies in how they react to fluctuations in stock market prices. The speculator focuses solely on extracting profit from correctly anticipating downward movements or upward movements in any particular market. In contrast, the investor is simply concerned with purchasing a valuable asset at a reasonable price, with the ability and readiness to hold it indefinitely. Misjudged market movements can spell heavy losses or even financial ruin for the speculator. Being surprised by the financial headlines, for the investor, is just another day.
– Barsky, Robert B., and J. Bradford De Long. “Why does the stock market fluctuate?.” The Quarterly Journal of Economics 108.2 (1993): 291-311
– Baker, Malcolm, and Jeffrey Wurgler. “Market timing and capital structure.” The journal of finance 57.1 (2002): 1-32.
– Graham, Benjamin. The intelligent investor: A book of practical counsel. Prabhat Prakashan, 1965.