This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
In 2020, Morgan Housel released The Psychology of Money. I think it deserves to be on the Mount Rushmore of investing books, especially for folks who believe history and behavioral psychology are critical elements for investing.
In the book, Housel has a section describing the stock market as a field where multiple games that have nothing to do with each other are being played at once. To quote from the book:
Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are.
Here's why this simple concept has lifelong impacts on your money and why it's the best investing lesson I ever learned.
Understanding a stock's price
A stock's price at a given time is merely a representation of the consensus value determined by buyers and sellers. But many of these players' motives and reasons for buying or selling the stock are completely different from yours.
For example, you have retail investors and institutional investors. Retirees and college kids. Long-term investors with multi-decade time horizons and day traders. Short-sellers and folks who only stay on the long side. Options and futures traders and those who only buy shares in stocks. The list goes on and on.
Housel's point is that many of these games have conflicting influences over the price action of a given stock. And for that reason, the price of a stock seldom resembles its long-term intrinsic value.
The tug-of-war between greed and fear
At certain times, the price of a stock can be dominated by greed and, at other times, it can be dominated by fear. In today's brutal bear market, that means you have some traders who may dump perfectly good growth stocks and move into value simply because they are fearful.
They decide they would rather own a stable business with a good balance sheet and positive free cash flow than take a risk on a company whose value comes from what it could be worth in future years and not what it is worth today. As a result, we continue to see exciting growth companies with a lot of potential get sold off heavily in the short term due to panic.
On the flip side, a lot of value stocks, and oil and gas stocks, were arguably underappreciated in 2020 and 2021, while some growth stocks saw their valuations get ahead of themselves. In those years, we saw investors take more risks and cast out companies with low growth. We saw a disregard for the geopolitical importance of utilities, energy stocks, and defense stocks in favor of bets on the next big thing.
Real-world examples
The point here is that you can gain clarity by remembering that a lot of the money in the stock market is playing a completely different game than you are. Once you understand that, it's easy to see why an excellent company like Amazon can fall by over 30% in a couple of weeks for little more than a mediocre earnings report and broader market volatility.
Let's take the example a step further with a stock like Shopify (NYSE: SHOP). Shopify closed the 2019 calendar year at just under $400 a share. It gained tons of momentum during the pandemic as e-commerce grew and the gig economy went into full effect. It ballooned to a market cap of over $200 billion and an all-time-high price per share of $1,762.92 on November 19, 2021; and has since slid to its current price of around $335 per share.
Shopify stock embodies several different games being played at once. On the one hand, you have long-term investors who believe in Shopify's ability to add new merchants, have existing merchants upgrade to more expensive plans, and have those merchants earn more money which benefits Shopify. Then you have a series of folks who were only buying Shopify as a short-term 'pandemic play' and don't care about the underlying business -- which was a big reason why Shopify stock ran up too far, too fast in 2021.
But today, you have yet another game being played -- the game of losing patience by selling growth stocks that make little to no profit and seeking cover in safer names. Once an investor realizes these conflicting games, it starts to make sense why a stock like Shopify can go from boom to bust. It doesn't make the price action in either direction right; it just helps explain why it happened in the first place.
A lesson from Warren Buffett
Warren Buffett is an excellent example of an investor who knows exactly what game he is playing. Buffett has repeatedly admitted he is unlikely to outperform a raging bull market because he doesn't invest in many growth stocks and sticks mostly to value. But he still believes he will outperform the S&P 500 over time -- which has been true over his long-term track record.
Berkshire Hathaway's portfolio may look overly conservative as it contains a lot of insurance companies, banks, oil and gas stocks, and consumer staples companies. But for Buffett, these are the kinds of businesses he wants to invest in. It's his game, and he's playing the stock market according to his own rules and risk tolerance.
An individual investor has no control over the broader stock market. So, imposing control over our investment decisions and style is the best way we can feel comfortable and achieve direction when stock prices seem to rise and fall randomly.
The silver lining
For long-term investors in stocks like Shopify, the whipsaw price action of 400% gains followed by 80% losses in just a two-year period can be confusing and annoying. It can be hard to know a fair price for a company when conflicting motives are tugging at its stock price. However, there is a silver lining.
Over time, fundamentals always win out. One look at the stock charts of successful companies like Nike or Apple, and you'll quickly see that sell-offs are simply par for the course for a successful long-term investment.
The beauty of long-term investing is that it is one of the few games where the odds are in your favor. The stock market tends to fall faster than it goes up but goes up more than it goes down. The average compound annual growth rate of the S&P 500 with dividends reinvested since 1965 has been around 10.5%. That's a massive tailwind for long-term investors to benefit from compound interest.
By investing in quality businesses that you understand and letting time be an ally, an investor stands a better chance of ignoring the noise of the market and focusing on what matters most.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
