Thursday, January 24, 2008

Mr Market and the ice-cream machine

Global stock markets are technically in a bearish mode, defined as falling 20% below the previous peak. The other well-known technical indicator is 2 consecutive quarters of negative GDP growth equals recession. Guess most pple know this one right?

In this kind of market, it is natural that most participants feel very down. Especially those who don't have a clue about stocks, trading, investing and entered the markets hoping to make a quick buck bcos their friends/colleagues did just that. Or maybe they heard stories of how pple made quick bucks buying COSCO, hold it for a few weeks and made a couple thousand dollars.

Well, now the stories become how pple loss 50% of their portfolio in one month and in absolute terms translate to $15,000-$30,000. They are in so much pain that they cannot eat, cannot sleep, don't want to hear anyone mention sto.., sorry you are not allowed to finish the word. Ok, if you know any of these people, ask them to come here and this blogger shall play Uncle Agony today.

Buffett and his predecessors like to use this term Mr. Market to describe the stock market. For more info on Mr. Market, click the hyperlink. Well the point I want to make here is that Mr. Market, or rather the stock market is like the Hokkien auction coordinator. He keeps shouting prices day in day out. And the prices are dictated by his emotions and they are usually not rational ie. they do not reflect the true value of the stocks.

For now, let's digress a bit. Let's say you bought this ice-cream machine that makes you fantastic vanilla ice-cream that you can sell for $5 per ice-cream, for many many yrs. Then someone comes over today and tells you, "Hey your ice-cream machine is only worth 50 cent, sell me now!", what do you do? Of course you ignore this mad guy right? Then suddenly next day he appears and again tells you, "Hey your ice-cream machine is worth $10,000, sell me now!" In fact, he will come everyday and quote you a price. So should you go happy like a bird when he says it's $10,000 today, and go appetiteless, sleepless, depressed when he says it's 50 cents tomorrow?

Well if you didn't know what you have bought and couldn't care less and the only thing in your mind when you bought it is that you think you can sell it few weeks later at a 15% profit, then, you should be appetiteless, sleepless, depressed bcos now you can only sell it at 50% lower than the price you pay.

But the good news is, if you hold on to it long enough (like 20 years), it's got a good chance that it may cross your buying price. Bcos the average return for stocks is 5-10% per year, so even if it dropped 50% this month, in a worst case scenario, say if the stock only goes up for 5% per year for the next 20 years, it will rise by 100% and reach your buying price. Meanwhile you can decide if you should be appetiteless, sleepless, depressed for the next 20 years. So that's consolation from Uncle Agony. Doesn't help much I guess, hehe.

But if you took pain to calculate how much your ice-cream machine is worth. And took pain to do research, to wait for a good price to buy the machine. Even if conditions are bad today and you can only sell your machine for less than its true worth, you know it's ok. Bcos you know some day, its value will be recognized.

Of course, humans cannot escape from emotions. Even the most experienced value investors feel the pain when their stocks decline 50%. However it is the philosophy that is important here. When the market is shouting that you are wrong, your stock is worth 50 cents, it doesn't mean that you have to be depressed. Re-look into your analysis and see if there is any truth. Usually there isn't, so be resolute and ignore the noise. It is your ice-cream machine, your stock, you don't need someone to tell you how much it's worth. It make take years to prove your point, that's investment, that's the stock market. You have to live with that in order to play this game.
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