It seems like once or twice a year for the last few years, we’ve had to address concerns with short-term volatility, usually in the equity (stock) markets. We’ve addressed this most important issue several times already (here) and (here) and (here) and (here), and today we felt it was important to remind our clients to do their very best to ignore the daily swings in value that are happening at the moment.

What causes panic in most people is that we aren’t sure why the drops are happening, and we don’t know when it will stop. It’s uncertainty, and not being able to see the future, that makes you panic as an individual investor.

The investing world, as a whole, is no different. Read the headlines and the first few lines of every news story about market volatility during the past few weeks and you’ll see the same worries played out over and over again.

(Emphasis ours.)

It’s clickbait. It’s all emotion. It’s even hysterical.

Get enough of that GroupThink happening, and you’ll most definitely see temporary drops in the markets.

At nVest Advisors, we try our best to understand the emotional dynamics underlying most investing decisions. We’re also keenly aware of how often those emotions harm our clients’ investing goals rather than help them. Keeping your emotions out of your investing is one of the most important things we can do for our investment advisory clients.

Instead of reminding you again about how the perspective of more time gives market volatility an entirely different appearance, or of how news media, American news media in particular, exaggerate and hyper-emotionalize the bad news to keep you tuned in, we want to give our clients (and blog readers) a quick primer on the interaction between real, measurable market values, and emotional “stretches” that happen all too often and create this whiplash of volatility that makes so many of us seasick.

At any given time, there are three variables that, when combined, make up the price of every investment:

  • First, we have the actual, objective value of the item (be it a house, stock, ounce of silver, etc.) The objective value of a stock is calculated in several different ways, but one easy one to look at is the BOOK VALUE of the company (how much in physical assets the company owns), along with how much profit it currently creates with those assets, per share of stock (this is usually calculated as a PRICE/EARNINGS RATIO). You might also pay attention to how much profit the company distributes to its owners (called a DIVIDEND), if that’s one of the criteria you have when choosing something to invest in.

 

  • The second part of a stock’s price is simply speculative but mathematical guesswork of the future viability of the company, based on industry trends, guidance from the company itself, and, many times, just loudmouthed opinion-makers on cable news channels. Do we think its business will grow, decline, or remain stagnant? This part can be right or wrong, but only time will tell, and it’s always – at best – an educated guess.

 

 

Think of it this way: if you were a classic car collector, how much is a 1968 Mustang objectively worth? Not a lot. Without the emotional component of certain people wanting one, they’re just aging, high-maintenance 50-year-old hunks of metal.

So the three parts of valuing a company’ stock are FACT, PROJECTION, and EMOTION. Only one of those is real.

Let’s take a real example. Please note that this is in no way a recommendation, as we would never do that without a signed client agreement. But we want to use a real stock with real data to let you see how this plays out.

Facebook (FB) share price chart, July – November 2018. NOT A RECOMMENDATION.

On September 4, 2018, Facebook (FB) was selling for $175.75 a share. A stock’s price at any given moment is what is deemed fair both by people wanting to buy and sell shares of FB that morning, based on the combined three parts of a price we mentioned above.

As we write this today, November 20, 2018, Facebook is selling for $132.30 (mid-day). A drop of $43 a share, or 24.8%, since September 4. (We have no idea where FB will be by the end of the trading day, by the way.)

What caused this drop?

Was it a sudden decline in the physical assets Facebook owns? Did they sell off a building? No.

Was it Facebook’s profit? No. Facebook is trending up quarter after quarter in earnings per share, currently at $7.40 per share, and that’s an improvement of 43.29% more profit than the same time last year.

Is Facebook announcing that they expect profits to drop soon? No. The reverse, actually.

So why the drop in price?

EMOTION. Nothing more. Investors fear government regulations may be looming for social media companies. Some feel angry with the apparently feckless and tone-deaf leadership of FB’s top brass. And finally, some people simply believe Facebook’s price was pushed too high on other people’s blind optimism.

But the company itself is doing just fine.

That’s true of almost every company in our economy right now. Times are, objectively and empirically, very good. The economy is booming. Wages are rising. Fuel prices are dropping. And by and large, we’re all doing better, so we feel better.

And when we feel optimistic, we take chances. We start new companies. We expand existing ones. And (this is key) we keep buying more of what’s performed so well recently.

Without realizing it, we over-inflate the third part of a stock’s price; we “stretch the rubber band” quite a ways. Investment gurus sometimes call this a “bubble”, but we think the rubber band analogy works better. Here’s why:

When you stretch a rubber band, at some point, it will reach a point of maximum resistance; where it can’t push further without breaking. Markets can do that, too, when we get overly optimistic and everyone is putting more and more money in. That creates stocks that are overbought.

But at some point, the rubber band is going to snap back to its original shape. In the investment world, this is called “REVERTING TO THE MEAN” – basically, it means removing all the emotional add-on that the third part created (good or bad), and snapping back to the real value of a company, based on actual assets and performance.

But will the stock collapse? Not as long as there is still inherent value in the company. It will simply “snap back” to its true, objective value.

Sometimes the rubber band can snap back too far because of overly negative emotions, and a company’s stock price can be too cheap – a bargain. But again, the price will eventually revert to the mean, which gives value investors an opportunity when they see a stock that’s been oversold.

The Cycle of Market Emotions

This pattern, of emotional buying to excess, then emotional selling to excess, is sometimes called the Cycle of Market Emotions. What goes up will eventually go too far up, and what comes down will eventually go too far down.

This simple illustration is why you can never let your current emotions dictate your investing decisions. Our emotions will always want to buy more when the rubber band is already stretched too high, and sell when the inevitable snap-back happens.

To use Wall Street parlance, that means we are accidentally “buying high and selling low,” because our emotions are in charge.

In reality, we need to do the exact opposite of what our emotions are nagging us to do, and that is really hard for most of us. (Shameless plug – if you find yourself struggling with this right now, it might be time to place much of this in professional hands. Book a little time with us to see if we’d be a good fit.)

Will the markets continue to bounce around? My guess is, probably. That’s totally normal and expected behavior. As an investor, you can’t control that. What you can control, however, is how you respond.