Tuesday, January 29, 2008

Intrinsic Value of the Whole Economy

In the previous post, I discussed the idea that a stock has an intrinsic value that is different from the current price of the stock. The stock market can become irrational and sometimes value a stock well above or well below its intrinsic value creating profitable opportunities for knowledgeable investors.

So what? Most of us can’t figure out the intrinsic value of a stock any better than we can pick lottery numbers. If you’re like most people who fall into this camp, your best bet is probably to avoid individual stocks and invest in low-cost broad index funds. (See this post for more about index funds.)

There are index funds that allow you to own a small slice of an entire economy. You can own your share of stocks in the US, Canada, and other countries. The better index funds have very low Management Expense Ratios (MERs).

The stock market as a whole has an intrinsic value just like an individual stock. US markets dropped about 10% in the first 3 weeks of January. Is it really plausible that the long-term prospects of the US economy dropped by 10% in those 3 weeks? Of course not.

Whether you are optimistic or pessimistic about the US economy over the next 50 years, there hasn’t been enough new information in 3 weeks to lower its intrinsic value by 10%. If the US goes into a recession, how much difference will that make over 50 years?

Stock markets fluctuate much more wildly than the total intrinsic value of the businesses that make up the market. In the short term, prices can move away from intrinsic value, but over the long term, the stock market must track the total intrinsic value of the businesses. If you believe that the economy will eventually recover from a downturn, then you can be confident that the stock market will recover as well.

If you believe that the US is doomed to lose out to other countries over the long term, then you shouldn’t hold US stocks, bonds, real estate, or even US dollars. If you believe that the US economy will chug along much as it always has with good periods and bad, then index funds are a good investment.

The next time stock prices drop sharply, stay calm. If you believe in the US economy over the long term, then you can be confident that prices will recover eventually. Just don’t put money in the stock market if you’re going to need it soon.

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