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To understand how markets work one needs to listen to what people say and watch what they do at the moment. This is why I get much of my information from daily media. I want to hear the actual wording respected investors use to describe their investment decisions. I save roughly 8 articles, transcripts and etc every day to document my process. You need something close to ‘at the moment of decision’ information because people tend to add other reasons to actions which were truly ‘gut decisions’ when asked later about decisions which were really based on years of experience for which they did not have a ready explanation. Once you recognize that the best investors do not know how to articulate how they actually came to decisions in the moment, you realize only later that they provided reasonable explanations so that they did not sound ‘stupid’ when they were asked by media pundits. You also come to the conclusion that it is only by reading everything available that you are able to reverse engineer ‘how the best investors think’. You have to develop an understanding from what very good investors say vs. what it is the investment , because they are not able to accurately articulate their mental process. And it is a mental process as Buffett has told us many times. He says often that he does this all in his head ‘My brain is a computer.’It takes substantial work to root out how people think, but once you begin the process it leads to the approach I talk about. You must read about human history with biographies being at the center of focus. Your focus is to understand how historical figures’ thinking works. It becomes both a broad and individually focused study of human history regarding financial markets. After a point, you begin to understand that Value Investors carry an innate sense of a long term valuation benchmark in their heads. Knut Wicksell was one of these. He articulated the concept of the ‘Natural Rate’ even without the reams of data we have available today. Bingo!
Michael Mauboussin: Here’s what active managers can do
Then you come to realize that investors accept the concept of stocks and bonds as a means of achieving returns above that available in one’s economy. Bingo again! Stocks and bonds offer returns above the ‘Natural Rate’ and is the reason we have investment markets in the first place. Because markets evolved slowly over time, we have accepted them without understanding that market returns exceed GDP. Long term GDP growth rate is our unspoken benchmark. We never think of the concept, we just invest.
You also quickly come to the conclusion that market prices are controlled by what the ‘collective we’ thinks things are worth, i.e. market psychology. This causes you to realize that all the math applied to markets since Bachelier (1900) has been misdirected effort. It is impossible to relate prices from one time period to another when both are based on human psychology which we can never measure. It is the fact that we take numbers as hard values in science and then because we have numbers as market prices we think they carry measurable information. Prices in any market are human perceptions of what something is worth.
For example: We ascribe a value to a collection of cloth, resin, pigment and wood because it was assembled by an artist we view as famous, but if our lives depended on keeping warm most of us would see works of art as a source of heat in the moment. The worth of many things are based on our circumstances. Markets in anything are certainly a collections of values dependent on circumstance.
Once one sees that market psychology sets prices, one quickly recognizes that ,even though each investor thinks of themselves as having a unique perspective, only two investor types actually exist, i.e. Value Investors and Momentum Investors. Value Investors are like Buffett. They have long term GDP as their internal benchmark. Momentum Investors believe in the concept of ‘The Invisible Hand’ or Eugene Fama’s ‘Efficient Market’ concept. Momentum Investors believe price trends carry invisible information which they use mathematics to analyze and describe and set investment decisions.
The key to really using all this is to understand that Value Investors are a very small number and exert their influence on prices mostly at market bottoms when they buy. This is where my phrase ‘The 1% Solution’ comes from. This phrase reflects the concept that it is only a very few investors, i.e. Value Investors, who set market lows from one cycle to the next. These are the investors who set the 70yr uptrend we see in the SP500 with respect to earnings. They see this uptrend mentally. Momentum Investors invest only in the near term trends they see and make up the vast majority of investing perception. In actuality it is not likely that 1% of investors control long term stock prices, but it certainly is a small percentage from all that I have read.
Soo…for the last 100+ years we have applied mathematics to help our understanding of investment markets when in truth this was simply the wrong thing to do. We have given Noble Prizes to solutions and concepts which did not hold up over time trying to spur a better market solution when all along we were missing the basic fact that market prices did not carry concrete information as numbers do in science. Scientific measurement of something such as the boiling point of water is a fact that does not change vs. circumstance once we understand all the science. Market prices are circumstance dependent and simply cannot work in any mathematical analysis. (Fortunately, I have had years of scientific training and have never made this mistake)
What I have explained above is the basis for the SP500 ($SPY) Intrinsic Value Index.