For you to make money any profitable investment has to increase in value somehow. If you buy a stock for $1 and sell it for $2, you've made money. Sell it for more than you paid for it to make a profit. Simple, right? Yes, but the details of making money in the market aren't easy.
To make a reliable profit from investing, you must understand what a stock is worth and what other people are willing to pay for it. Only then can you evaluate any specific opportunity. Is now a good time to invest? If you've found a good opportunity, the answer is always yes!
Why Do Stock Prices Fluctuate?
In the long term, the stock market does a pretty good job of figuring out what each individual company is worth. In the short term, stocks go up and down for many reasons, but only some are rational. Some companies are scams, like Enron, and they'll eventually fall apart. Good companies make real money. Solid businesses will succeed and continue to be good.
On any given day, a stock price may drop because of a rumor about its business, a report from an stock analyst (which may be right or wrong), broad macroeconomic news, one person or fund selling a lot of shares to take a profit (or avoid a tax liability or to free up funds to invest elsewhere), or countless other reasons. Those reasons may have nothing to do with the underlying business, but they'll change the price anyway.
Economists like to talk about perfectly rational actors and efficient markets, as if investors always follow a set of hard and fast rules. They don't. There are many different players and many different strategies. Not everyone investing pursues value investing. Not everyone evaluates the financial information of the business in terms of free cash flow. This can give you an advantage.
Many people invest because they think they can outsmart the market by identifying and taking advantage of patterns and trends before other investors do. That's tricky. Instead of calculating based on actual numbers (and adding in a margin of safety to protect against the unknown), they try to predict the behavior and beliefs of countless other people. Even if their decisions ignore the underlying business value of stocks, their trades move the market too.
Why Do Business Values Fluctuate?
Stock prices do move because business valuations change.
When Canadian Maple Syrup Inc announces that it's going to spend $100 million dollars building a new factory and won't pay a dividend in the next quarter, some people will sell. In fact, it won't record a profit in the next quarter because it's putting so much revenue into expansion. There may be good business reasons to build the factory (as an investor, you certainly hope so), but some people will sell the stock because they want that dividend—they want a business which has profitable quarters.
None of that makes this a bad investment. It may get even better, if sellers drive the price down to a good discount.
Another company may announce that it's losing money—not investing all of its profits in growth, but actually losing money. That stock's price will probably drop due to its financial situation.
Neither situation is irrational. Both situations have roots in the actual financial performance of the business. Perhaps not every trade related to the stock will reflect a concrete valuation based on business value, but these decisions give concrete evidence as to why the stock's price will change.
Price Changes Create Opportunities To Invest
Even though the market isn't always rational when it prices a stock day to day, value investors have many opportunities to buy great companies at good prices. The important questions are how to identify the how and when to buy stocks to take advantage of those opportunities.
To exploit a market inefficiency for a stock, you must understand the value of that stock and the story behind the business. Is it a cyclical business? A short-term hit to profits and dividends for Canadian Maple Syrup Inc hopefully represents greater growth in the long term. If you're in it for five or ten years, the discounted price you'll pay today may be worth the value you get over that period (even with the missing short term dividends).
You can't necessarily predict the free cash flow or owner earnings the business will realize with the new factory, but you can go back to your discounted present value calculation to see if the price has dipped to the point where it's an obvious bargain.
What if the price drops further?
This question scares some people away from good opportunities! Bigger price drops mean better bargains. Perhaps you can buy more stock and make a bigger profit in the future. That can be difficult to swallow as you question your underlying valuation—what if you did the numbers wrong? Keep your margin of safety in mind.
Yet don't mistake short term losses on paper for long term problems. If you never invest, you'll never lose money—and you'll also never make money.
Should You Sell in May and Go Away?
What's the right time of year to buy stocks? One piece of market folklore (Sell in May and Go Away) suggests that the market tends to reach a high point in May or early June and then drop until September or October before climbing again. This rule of thumb (the first warning sign) purports to explain observed behavior (a second warning sign) of the market as a whole (the third warning sign).
Investors and analysts and brokers do go on vacation in the summer months and have less time or desire to invest. The volume of trades can go down in this time period—but what does that have to do with the price of any particular stock?
Even if you've invested heavily in an index fund (as you should), knowing when to sell (and face short term investing tax penalties) and when to buy a stock back (and pay trading costs both times) will be difficult. You'll lose out on dividends and unexpected gains. If the dip in price is true and you reinvest your dividends, you'll actually reinvest at a discount (thank you, dollar cost averaging!).
If you're investing over a period of decades, the minor fluctuations of a couple of percent over a couple of months isn't worth getting upset over.
When to Buy and Sell Stocks
Because the market is so often irrational in the short term—one day, there might be more sellers than buyers, and the price per share may drop more than the sellers intended—a great stock can go on sale for reasons unrelated to its financial position. To exploit that possibility, you need a list of good potential stocks to buy, a list of fair prices you think they're worth, and the cash on hand to take advantage of these bargains.
The best time of day to buy stocks is when they're on sale. The best time of year to buy stocks is when they're on sale.
Keep your stories about these stocks up to date. Understand why you believe they're worth what you think they're worth. Don't let market hype pro or con sway your valuations or tell you when to buy and sell stocks. The right time to invest is when you've found a bargain. That may not be in May. That may not be when an analyst changes the target price. That's when you have the right opportunity to buy the right stock for you at the right price.
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