How Stocks are Priced, Part 4 – Emotion Factors

This is a continuation of the series of posts on stock pricing.  Today we come to the somewhat irrational factors that go into stock pricing, which I call the Emotion Factors.   The first post of the series is here:

One must remember when thinking about stock pricing that there is no exact science.  There is not some magical equation that sets the price.  Likewise, unlike a store, there is no one actively setting the price.  Stocks are priced based on the auction system.  This means that no matter what the fundamentals are, in the end stocks will be priced at whatever someone is willing to pay at the current time.

While pricing will always come back to rate of return (the fundamental factors) compared to other investments (the comparative factors), the emotions of investors can drive the price through wild swings.  An analogy I like to use is that the price of a stock is like a river.   If earnings are increasing regularly there will be a steady current pulling things downstream, such that if one waits long enough a fairly good guess of where something floating in the water will be.  In the short-term, however, there may be all sorts of eddies, pushing things in unpredictable ways.  At times things will even move upstream.  These eddies are the emotional factors.

“The crowd” always tends to buy at the wrong times and sell at the wrong times.  The crowd will be buying shares when they are priced too high and selling them when they are at bargain basement prices.  Because of this, stocks that are going up tend to keep going up long after they have advanced beyond any reasonable price based on the fundamentals.  Likewise, stocks that have fallen will tend to stay down even if they are at a low price relative to earnings and other factors.

Like the teen fashion market the actions of the crowd are difficult to predict.  For the long-term investor it is best to simply ignore the effects of the crowd.  The only exceptions are that 1) one can take advantage of the low prices created by a stock being out-of-favor to buy into the stock and 2) when a long-term pick gets bid up so far that it will be a considerable amount of time before the earnings will justify the share price, the investor may wish to sell out and buy into a more favorably prices company.

To ask a question, email or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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