“Trend is your friend” says the old wisdom – whether true or not. Anyway, people have a great need to believe in the continuity of stock price trends. Over-extrapolation or believing a trend will carry on just because it has done so in the past is very deep in people’s herd mentality. While the past record is maybe the best way to assess what’s likely to happen in the future, it’s still not always very reliable. Too often analysts have been persuaded to extrapolate a trend forgetting to allow for the potential for the law of diminishing returns or for the impact of increasing competition to decrease the growth trajectory.
Investors often extrapolate evidence from recent trends and then decide to buy or sell. If it were easy to pick stocks based on recent price trends alone, most mutual fund managers would be able to beat the market indices. But most of them don’t. For every trend that continues, ther is probably another one that does not.
The reason for that is mean reversion. Mean reversion just means that over time results will tend towards some average. In business, companies tend to revert back to a typical level of profitability over time. Firms that are suffering from poor profits tend to increase their profitability over time while companies with exceptional results will see those results deteriorate in the future.
You don’t have to be a genius to understand that in the short run the price of a stock can deviate substantially from its basic intrinsic value, because market participants may betray a herd instinct in their behavior. This is probably the most important concept that you need to know about market psychology. When people don’t understand a company and its inrinsict value well, they prefer follow the crowd. They chase the winners (increasing market price trend) and dump the losers (decreasing market price trend) indiscriminately.
Because of herd mentality and psychological reasons, the entire market – and at the same time individual stocks – may go up and down dramatically. The behavior of the crowd stems from greed and fear. A little disappointment or a positive surprise and world markets react substantially. It is extremely difficult to time the market or to forecast events that make markets move striking. The lesson to learn is that when the market does go down or up significantly, prime buying or selling opportunities may surface. Do you remember a funny fellow which already Benjamin Graham once called Mr. Market?
How does an investor then should act? The investor must trust his own fact-based and independent analysis of his or her investment. It is based on determination of the true intrinsic value of the company. You can call it also the value of the company to a private owner. It is the price at which a stock should sell of properly priced in a normal market. This price should be justified by the facts, like company’s earnings, assets, dividends and future prospects.
Since the exact valuation of a company is difficult, we have ti accept, that at its best we can only estimate the intrinsic value range. Because of this, the value of the stock must be well in excess of the price paid. This margin of safety protects us from minor valuation errors, and from market and company-specific negative surprises. It is kind of insurance against untoward occurences. Even if something went wrong, it is still possible to obtain a satisfactory return.