In 2020, Morgan Housel published The psychology of money. I think he deserves to be on the Mount Rushmore of investing books, especially for people who believe that history and behavioral psychology are essentials to investing.
In the book, Housel has a section describing the stock market as an area where several games that have nothing to do with each other are played at the same time. To quote the book, “Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing games different from you.” Here’s why this simple concept has lifelong impacts on your money, and why it’s the best investing lesson I’ve ever learned.
Understand the price of a stock
A share price at any given time is only a representation of the consensus value determined by buyers and sellers. But many of these players’ motivations and reasons for buying or selling stocks are completely different from yours.
For example, you have retail investors and institutional investors. Retirees and college students. Long-term investors with decades-long time horizons and day traders. Short sellers and people who only stay on the long side. Options and futures traders and those who only buy stocks. The list is lengthened increasingly. Housel’s view is that many of these plays have conflicting influences on the price action of a given stock. And for this reason, the price of a stock rarely resembles its long-term intrinsic value.
The showdown between greed and fear
At times, the price of a stock can be dominated by greed, and at other times, it can be dominated by fear. In today’s brutality bear marketit means you have traders who can dump perfectly good growth stocks and go to value just because they are scared and would rather own a stable business with a good balance sheet and positive free cash flow than take a risk on a business whose value comes from what it might be worth in years to come and not what it is worth today. As a result, we continue to see exciting growth companies with lots of potential selling off massively in the short term due to the panic.
On the other hand, a lot of value stocks and oil and gas stocks have been probably underestimated in 2020 and 2021, while some growth stocks have seen their valuations take a lead. Over these years, we have seen investors take on more risk and reject low growth companies. We have seen a disregard for the geopolitical importance of utilities, energy stocks and defense stocks in favor of betting on the next big thing.
The point here is that you can gain clarity by remembering that much of the money in the stock market is playing a completely different game than you are. Once you understand this, it’s easy to see why a great company like Amazon can drop more than 30% in a matter of weeks for little more than a lackluster earnings report and broader market volatility.
Let’s take the example a little further with a stock like Shopify (STORE -10.57%). Shopify ended calendar year 2019 at just under $400 per share; gained momentum during the pandemic as e-commerce grew and the gig economy kicked into full effect; reached a market capitalization of over $200 billion and a record price per share of $1,762.92 on November 19, 2021; and has since slid to its current price of around $335 per share.
Shopify stock embodies several different games played at once. On the one hand you have long-term investors who believe in Shopify’s ability to add new merchants, upgrade existing merchants to more expensive plans, and have those merchants earn more money, which benefits Shopify. Then you have a series of people who were only buying Shopify as a short-term “pandemic game” and don’t care about the underlying business – which was a big reason why Shopify’s stock has grown too muchtoo soon in 2021.
But today you have yet another game going on — the game of losing patience by selling growth stocks that are yielding little or no profit and seek cover in safer names. Once an investor realizes these contradictory games, they begin to understand why a stock like Shopify can go from boom to bust. This does not make the price action correct both ways; it just helps explain why it happened in the first place.
A lesson from Warren Buffett
Warren Buffett is a great example of an investor who knows exactly what game he’s playing. Buffett has repeatedly admitted that he’s unlikely to outperform a raging bull market because he doesn’t invest in many growth stocks and mostly sticks to value. But he still believes that he will surpass the S&P500 over time – which is true for its long-term track record.
Berkshire Hathaway Portfolio may seem too conservative as it contains many insurance companies, banks, oil and gas stocks, and consumer staples companies. But for Buffett, these are the types of businesses he wants to invest in. It’s his game, and he plays the stock market by his own rules and risk tolerance.
An individual investor has no control over the broader stock market. So, imposing control over our decisions and investment style is the best way to feel comfortable and achieve direction when stock prices seem to rise and fall randomly.
The silver lining
For long-term investors in stocks like Shopify, the rollercoaster price action of 400% gains followed by 80% losses in just two years can be confusing and boring. It can be difficult to know the right price for a company when conflicting motives weigh on its share price. However, there is a silver lining.
Over time, the fundamentals always win out. A look at the stock charts of successful companies like Nike or Apple, and you’ll quickly see that sales are just normal for a successful long-term investment. The beauty of long-term investing is that it’s one of the few games where the odds are in your favor. The stock market tends to fall faster than it rises, but it rises more than it falls. The average compound annual growth rate of the S&P 500 with dividends reinvested since 1965 has been around 10.5%. This is a huge tailwind for long-term investors benefit from compound interest.
By investing in quality companies you understand and allowing time to be an ally, an investor has a better chance of ignoring market noise and focusing on what matters most.
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