Monday, March 26, 2012

What Should Investors Wish for?

You’ve just plowed some hard-earned money into the stock market. You watch the second-by-second price changes of your latest purchase. Each little increase validates your latest investment decision, and every time the price drops a little you feel some of your life energy drain away. But once you get some control over your emotions, what should you really be hoping for? Many people offer simple answers, but the real answer is a little more subtle.

If you are entering retirement and will be selling stocks in the near future, it makes sense to want higher prices. But if you plan to be a net buyer of stocks over the next few years, you should actually be hoping for lower stock prices. However, the reason why stock prices are rising or falling is important for both buyers and sellers.

Broadly speaking, stock prices consist of two components:

1. A value based on long-term future prospects. This is sometimes called “intrinsic value.” Unfortunately, we cannot know the intrinsic value with certainty. Generally, the best guess is the current stock price.

2. A premium or discount based on such current market conditions as interest rates, levels of fear and greed, political instability, etc.

Anyone who owns stocks should be hoping for an increase in intrinsic value. Rising profitability and better future prospects for the businesses you own is a good thing whether you are planning to buy more or sell in the near future.

It is the second component of stock prices where buyers and sellers should differ in their hopes. Those who expect to be buying more stock should be hoping that fears lead to stocks being priced at ever-greater discounts to their intrinsic value. Sellers should be hoping for optimism that allows them to sell at ever-higher premiums to intrinsic value.

So, everyone who is invested in stocks should be hoping that our economy ticks along strongly and that businesses become stronger and more profitable. But buyers should be hoping that most people don’t recognize this strengthening of businesses. Buyers should want unwarranted pessimism about stocks. However, we should expect most investors to cheer rising markets whether this is in their best interests or not.


  1. I once made the point to a coworker that, given that the market is at point A now and point B in the future (when I start to sell my stocks), all else being equal, I definitely want it to be as low as possible in the mean time. :-)

  2. @Patrick: I find that this is a real eye-opener for some people.

  3. For the next 20 years, I'll take low markets for sure.

    In the end, it doesn't matter much since what will be, will be. I have no control over any of it.

    If you do though Michael, let me know your secret. I won't tell anyone :)

  4. @Patrick: Did your coworker look at you like you had 2 heads? I find people find this idea very strange at first.

    @Mark: I'm with you as long as they are low because of unjustified pessimism rather than a slow collapse of market-based economies.

  5. @Michael: Wow, good call. I got a pitying look and seemed to say "This poor guy thinks investing is all about math. He doesn't understand how it works in the real world."