Stocks school the fool

Question: Is it still safe to invest in the stock market at these high levels? —asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.

Answer: The stock market is an exciting place to be when it comes to trying to generate profits. But it is no exaggeration when people say that investing in the stock market is like riding a roller coaster. The risks are not for the faint-hearted or for those just looking for a safe place to park their funds.

Economists say that a company’s stock price reflects the true worth of the company because the price is set by the collective wisdom of people who are trading that company’s stock. Yet why is it that both excessive and deficient valuations still occur?

Market bull and bear runs both occur because packaged with the collective wisdom of investors is also their collective foolishness.

In bull runs, for example, investors get the feeling that the market’s momentum will continue moving prices higher even though they are already at unjustifiable levels fundamentally. The normal excuse given is that perhaps investors are now valuing stocks at a whole new level. This is backed by the relative “quiet” on the economic and political fronts, leading to the conclusion that nothing can make the market come crashing down.

In bear markets, investors are so pessimistic and convinced of the view that prices are falling into a bottomless pit, with all indicators pointing to a continuation of the fall. I remember as a fund manager during the 1997 Asian Financial Crisis that every day was marked with reports on the number of companies that were closing down in the Philippines.

In both bull and bear markets, both optimism and pessimism are blown out of proportion through compounded speculation. At their height, both optimism and pessimism are not anymore fueled by solid fundamentals but by hope and fear, respectively. And this hope and fear are simply based on sentiment, which Jesses Livermore, the world’s greatest trader, calls ignorance.

But just like nature, which is always trying to go back to its original state, through changes ranging from the mild to those of biblical proportions, markets also work to correct the excesses in both bull and bear markets. History has shown this to be true from the first known market collapse in the tulip-bulb craze from 1634-1637 to the global financial crisis from 2007 to 2008.

The best strategy to take in both bull and bear markets is first to manage funds using a portfolio of securities, not just one security. This way, diversification, which is to achieve the same target return at a lower risk, can be had.

Next, it is not wise to take a strong stand by completely overweighting (in bull markets) or underweighting (in bear markets). And if ever you want to make a strong stand, you will need to wait for a confirmation of the reversal of trends. This confirmation comes in the form of fundamentals (i.e. strong forecasted earnings growth) and technicals (i.e. a rise in volume of trades underlying the price direction you want to see).

Don’t let your emotions run wild when investing in stocks. If you do, then you are a fool. And fools are soon parted with their money.

At the end of the day, stocks are mere tools for achieving your goals in life in an objective and emotionless way.