In 2020, Morgan Housel released the psychology of money. I think it deserves to be on the Mount Rushmore of investment books, especially for people who believe that history and behavioral psychology are critical elements of investing.
In the book, Housel has a section that describes the stock market as a field where several games that have nothing to do with each other are played at the same time. To quote from the book, “Few things matter more with money than understanding your own time horizon and not being swayed by the actions and behaviors of people who play games different than your own.” Here’s why this simple concept has lifetime impacts on your money and why it’s the best investment lesson I’ve ever learned.
Understanding the price of a stock
The price of a stock at any given time is simply a representation of the consensus value determined by buyers and sellers. But many of these players’ motives and reasons for buying or selling stocks are completely different from yours.
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For example, you have retail investors and institutional investors. Retirees and university students. Long-term investors with multi-decade time horizons and day traders. Short sellers and people who only stay on the long side. Options and futures traders and those who only buy shares in shares. The list goes on and on. Housel’s point is that many of these games have conflicting influences on the price action of a given stock. And for that reason, a stock’s price rarely matches its long-term intrinsic value.
The tug of war between greed and fear
At certain times, a stock price can be dominated by greed and at other times, it can be dominated by fear. In today’s brutal bear market, that means there are some traders who may dump perfectly good growth stocks and move into value simply because they’re scared and would rather have a stable business with a good balance sheet and positive free cash flow than take a chance on a company whose value comes from what it might be worth in future years and not from what it is worth today. As a result, we continue to see exciting growth companies with a lot of potential being sold off heavily in the short term due to panic.
On the other hand, many value stocks and oil and gas stocks were arguably undervalued in 2020 and 2021, while some growth stocks saw their valuations come forward. In those years, we saw investors take more risks and write off low-growth companies. We saw a disregard for the geopolitical importance of utilities, energy stocks and defense stocks in favor of betting 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 yours. Once you understand that, it’s easy to see why a great company like Amazon it can drop more than 30% in a couple of weeks for little more than a lackluster earnings report and broader market volatility.
Let’s take the example one step further with an action like Shopify (NYSE: STORE). Shopify closed calendar year 2019 at just under $400 per share; gained tons of momentum during the pandemic as e-commerce grew and the gig economy came into full effect; soared to a market capitalization of more than $200 billion and an all-time-high share price of $1,762.92 on November 19, 2021; and has since dropped to its current price of around $335 per share.
Shopify stocks represent 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, get existing merchants to upgrade to more expensive plans, and make those merchants more money, which benefits Shopify. Then you have a bunch of people who were just buying Shopify as a short-term “pandemic play” and don’t care about the underlying business, which was one of the main reasons Shopify stock went up too much, too fast in 2021.
But today, he has another game at play: the game of losing patience by selling growth stocks that make little or no profit and seeking cover in safer names. Once an investor becomes aware of these conflicting games, it begins to make sense of why a stock like Shopify can go from boom to bust. It doesn’t make the price action correct in either direction; it just helps explain why it happened in the first place.
A lesson from Warren Buffett
Warren Buffett is a prime example of an investor who knows exactly what game he is playing. Buffett has repeatedly admitted that he is unlikely to ride out a raging bull market because he doesn’t invest in many growth stocks and sticks primarily to value. But he still believes that he will surpass the S&P 500 over time, which has been true throughout its long-term trajectory.
Berkshire Hathaway’s portfolio may seem overly conservative, as it contains many 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 tolerance for risk.
An individual investor has no control over the stock market in general. Therefore, 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 price action of whipping 400% gains followed by 80% losses in just a two-year period can be confusing and annoying. It can be difficult to know a fair price for a company when contradictory reasons are pulling up its share price. However, there is a positive side.
Over time, the fundamentals always win. A look at the stock charts of successful companies like Nike either Apple, and you’ll quickly see that liquidations are just normal 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 rises, but rises faster than it falls. The average compound annual growth rate of the S&P 500 with dividends reinvested since 1965 has been about 10.5%. That’s a huge tailwind for long-term investors to benefit from compound interest.
By investing in quality businesses that you understand and letting time be your friend, an investor is more likely to ignore market noise and focus on what matters most.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Daniel Foelber has positions at Shopify and has the following options: $600 September 2022 Shopify long calls and January 2024 $600 Shopify short calls. The Motley Fool has positions and recommends Amazon, Apple, Nike and Shopify. The Motley Fool recommends the following options: January 2023 long calls at $1,140 on Shopify, March 2023 long calls at $120 on Apple, January 2023 short calls at $1,160 on Shopify, and March 2023 short calls at $130 on Manzana. The Motley Fool has a disclosure policy.