Image Source: Kenzie Saunders
Let’s cover three important investing prompts.
By Brian Nelson, CFA
The Psychology of the Markets
“The stock market is a discount mechanism of future expectations. Period. Sometimes prices are rational and based soundly on reasonable future fundamental expectations and sometimes they’re not.” – Brian Nelson, CFA
Stop thinking chronologically, and start thinking psychologically.
Many investors believe that they can just buy any old stock that pays a growing dividend and hold it for decades, and that’s long-term investing. Selection bias aside, this has worked in the past for many an investor. There are hundreds of examples of this. But I think it is incredibly important for you to understand how to think about the long term, regardless of your investment time horizon. The long term is generally taught and presented chronologically (i.e. hold a stock for years), but instead it is a far more psychological phenomenon.
First, any intellectual conversation of the long term must consider the discounting mechanism of stock prices in how they discount future information, whether it is risk through the discount rate or value through the magnitude of free cash flows. The long term, therefore, is a far more complex concept than many make it out to be. In the future, for example, stock prices will reflect the expectations of a “new” future at that point in time, not the fundamentals of the past or performance from the past to present. This is why in “The 16 Steps to Understand the Stock Market,” we say the “long term” can never be attained. It’s fallacious to think so. As time passes, there will always be a new “future,” and a new “long term,” and stock prices will always change to reflect the moving target of these changing long-term expectations.
Apple (AAPL), for example, is/was/has been a great performing stock because its future today has a larger free cash flow stream expected in it (and lower risk ascribed to it) than that of the future of its past. Its future value today is larger than what it was in the past. The present value of expectations of its long term, a “new” long term, have changed over time. This is very important to understand. It is not the passing of time (chronologically), per se, why stock prices advance/decline, but instead it is the change in the market’s future financial forecasts of them (free cash flow and the like) +\\- net cash on the books at any point in the future that causes the stock price change (driven by buying and selling activity based on these changing expectations).
It’s psychological, not chronological. Because expectations of the future are always changing, and the future is inherently unpredictable, there can theoretically never be a determinate or definitive “long term.” In fact, there is only a series of iterative expectations of the long term that drive the stock prices of today and stock prices as time passes. If you understand this, you’re moving closer to understanding what makes the markets tick.