Don't Join the Queue
With everything that's been going on in the financial markets andthe media taking every opportunity to sensationalise each bit of news,it's worth taking a step back and try to see the wood for the treesagain.
The starting point of this exercise is to ask why people should consider investing in stock and shares in the first place?
Companies wanting to raise new capital to expand typically havethree main options available to them. Firstly, they can borrow it fromthe bank for which they will, over time, repay the capital plusinterest. Secondly, they can offer investors fixed interest bonds forwhich, over time, they will repay the capital and higher interest.Lastly and alternatively they can issue shares thus effectively sellingsome of the company to external shareholders.
In respect of borrowing from the bank or by fixed interest bonds,companies will do this if they believe that they can re-invest the loanto make more money than the costs of borrowing.
When companies issue shares to provide new capital for expansion,they do this because the company owners believe that they can re-investthe funds to make greater net gains, even though they will own less ofthe business as a result.
So, the first fundamental is that equities will be expected tooutperform both cash and fixed interest bonds. The second fundamentalis that in order to reduce the risk to individual companies, investorsshould spread their risk by investing in funds run by professionalmanagers who spread the fund assets over many companies in differentsectors.
Once a company has issued shares and they are available on astockmarket to investors, the next question is: what drives the priceof the shares on any given day? The simple answer is demand and supply- i.e. how many people want to buy the shares and how many want to sellthem.
It's similar, for example, to selling a porcelain collection at anauction. A seller is hoping that all of the potential buyers at theauction want to buy porcelain and that they are the only one selling.Buyers are hoping that they are the only ones buying porcelain and thatthere are many sellers. If there is competition between buyers thisshould drive the price up. If the reverse happens and everyone isselling porcelain to very few buyers, this will drive the price down.
This example translates through to the price of shares: if there aremore people wanting to buy shares than the number who want to sell themthen the price will go up; if there are more sellers than buyers, theprice will go down.
That's not to say that company profit forecasts and economic resultsare not important. Every investor, whether they are buying shares orproperty or antique collections, wants to believe that they are buyingsomething that will make them a profit over time. They are typicallyhappy to pay over the odds for something that they feel will still makethem a profit. In the case of company shares however, if either thecompany profit announcements are lower than expected or new economicdata indicates factors such as unemployment which will translate intopeople spending less on companies' products or services, thisinevitably results in investors re-considering whether they should keepthe shares or sell and re-invest in something that will give them abetter return.
This means that rather than company or economic news directlyimpacting the price of shares, it's the emotions of investors who usethis news to evaluate whether they should buy sell or hold depending ontheir own circumstances.
The herding mentality of the human race is never more evident thanin the stockmarkets where we are all sellers or all buyers.Unfortunately market data shows that by the time the equity buying bandwagon has reached the maximum, that's the time when markets startfalling. Equally, when the market has reached the bottom, that's whenno one is buying when they should be.
Looking again at the porcelain auction example, if you owned acollection you wanted to sell but learned that every other porcelaincollector would be at the next auction trying to sell their collection,you would probably say away. Alternatively, if you were a buyer, thensurely that's the auction you would want to be at.
It's strange and unfortunate that when it comes to stockmarkets,investors forget this logic and buy when shares look expensive and sellthem when they are cheap because everyone else is also trying to selltheirs.
So, the third fundamental is that investors should not follow theherd as those that do will generally lose out. This is because theywill have bought shares at a time when competition for them is high andthey will end up selling at a loss at a time when everyone is trying tosell theirs as well.
The fourth fundamental is that as a result of the human herdingmentality, share market movements tend to be over exaggerated, both onthe way up and way down, and are driven partly by emotion rather thanlogic.
So where does this leave us?
This is an uncomfortable time with poor economic news continuing tofilter through, but let's take a step backwards in order to lookforward.
Longevity is increasing so we are generally living longer and acrossthe globe there is a population boom. In essence, there are anincreasing number of consumers to which companies can sell their goodsand services to. The industrialisation and economic growth and freedomof China, India and the other emerging markets with far lower costbases than the West will allow companies to continue to move theirmanufacturing to cheaper markets, thus protecting and helping them toimprove their profits. Irrespective of the short term, these trendscontinue to support the view that equities remain a vital component toprotecting investors' wealth (after taking account of inflation) in thelonger term. In addition, interest rates are falling which enablescompanies to borrow for growth at lower costs and with the currentlower oil prices companies are able to distribute their goods toconsumers at lower costs, thus helping profits.
We may or may not have seen the bottom of the stockmarkets yet -however, as a result of the herding mentality resulting in wholesaleselling of shares, it appears to have created a false doomsdayscenario. This gives investors the opportunity to purchase equitieswithin a wide spread and diversified portfolio at what may prove in thefuture to be bargain prices.
Investors holding cash should now consider investing part of theirwealth in equities. Existing investors should not sell and in factcould consider increasing their exposure to equities at this time.