Thursday, September 4, 2008

Do You Cheer Your Stocks Up or Down?

Most people are happier to see the price of the equities they hold rising rather than falling. But, is this sensible for people who are in a phase of their lives when they are saving money and buying equities? Isn’t it better to buy things at lower prices instead of higher prices? I think that your feelings on this subject say something about you as an investor.

Warren Buffett has consistently said that he would be pleased to have the stocks he holds drop by 50% so that he could buy more cheaply. The reason he thinks this way is that he believes he has a good sense of the intrinsic value of the businesses he owns. You can think of stock prices as estimates of intrinsic value that may or may not be accurate.

Buffett is confident that if a stock price drops way below the intrinsic value of the business, the price will rise to meet the intrinsic value eventually. So, for him, low stock prices are a buying opportunity.

However, most people can’t estimate the intrinsic value of a business better than the stock market does. These people cheer their stocks up even when they plan to buy more. This makes sense if you see stock prices as the best available indication of the health of the business. In contrast, Buffett sees price changes as random gyrations taking the price closer to or further from intrinsic value.

Cheering price increases isn’t irrational; it’s just a sign that the investor belongs to the large majority who can’t do what Buffett does. Perhaps this could be used as a test of whether an investor should be a stock-picker. If you are in a phase of your life where you are saving and buying stocks and you cheer rising stock prices, maybe you should switch to index investing.

5 comments:

  1. Go Nortel, Go Entrust!!! Win, Win!!!

    Somehow neither of those stocks strike me as Buffett stocks, mind you.

    C8j

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  2. Don’t forget the question of dividends. If you decided, for instance, that our big banks are sure to see better days and were prepared to buy shares at discount prices, you’d still have the dividends to keep you warm.

    Let’s say you picked Scotiabank or TD. These two have kept away from the worst of the financial mess, but have still suffered considerable collateral damage … and made a few mistakes of their own.

    There’s no reason to believe these banks won’t return to their accustomed positions of strength, but how long are you willing to wait? How many so-so quarterly reports and share price dips can you stand? Are you prepared to buy on those dips? (Some would say pick CIBC since it has the most room to make up, but it may take longer too.)

    In part, the question can be framed in terms of the quality of the stocks themselves. Even if you’re perfectly willing to buy on falling prices, you have to be certain that the stock will recover. And it’s nice to have some income coming in while you wait.

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  3. I cheer up the stocks I already own, but cheer down the stocks I want to own!

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  4. RC: Of course, Buffett would say that if you intend to buy more of a given stock, then you should be cheering it down as well, even though you own it.

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  5. I hope you're cheering them down this week!

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