I want to tell you about four different companies' shares.
The first is up 1.3%, which is okay, but not spectacular.
The second? Down 1%, which is disappointing.
The third? Up 3.5%. Good, but not worth writing home about.
The fourth? It's gained a very impressive 24.6%.
Which one would you buy, today?
Some of us would buy the one that's down, hoping to snare a bargain.
Some of us would buy the one that's going up. Everyone loves a winner, and maybe it keeps on winning.
The only correct answer, unfortunately, is "I don't have enough information to know".
The market is full of companies whose shares fell… then fell further.
Also full of those whose shares fell… then rose.
There are plenty of companies whose shares rose, then kept rising.
And companies whose shares rose, only to fall again.
So using past share prices to make investment decisions is… courageous.
Instead, I reckon investors should be looking forward, not backwards:
Looking at what the company does, how well it does it, and how bright its future might be. Then working out whether today's share price is attractive, or not, relative to that future, not relative to any past share price movements.
But here's the kicker: Whatever view you drew of the four companies I presented above, I cheated a little.
They're the same company.
And that's the second lesson I want to impart, here.
If you owned those shares, you might feel differently about the company, based on the share price performance. We can't help but feel just a little smart (and/or smug) when the share prices of the companies we own go up. We tell ourselves that we were right.
When they go down? We can't help but feel just a little despondent. 'Maybe I'm wrong' we tell ourselves. Even when we have conviction in the companies we own, that confidence can be sapped by falling prices.
How can the same company have four different share price returns?
Time.
The first data point was one day's share price gain. The second was the last month. The third? The last six months. And the latter was the gain over the past year.
If you bought shares a day or a year ago, you're feeling pretty good.
If you bought them a month ago, you're in the red.
And if you bought them six months ago, you're up, but only a little.
Three or four different emotions, but the same company.
Now, I don't blame you for not being happy if you lose money.
But that emotion, as I mentioned above, can overtake us. Four investors, buying the same company on different dates, probably feel differently about that company… even though they'll all get the very same return from tomorrow onwards.
That, I hope, is the clearest way to demonstrate the power of emotion, and why getting your framing – focus on the future not the past – right is so important.
And one quick third lesson:
You'll hear people talk about listed companies based on their past performance. "Ah, Company X is a bad stock.. It's down 10%". Or "Company Y is a great share to own. It's up 15% over the past year".
What they're really saying is that those shares were up or down in the past.
But they're – consciously or unconsciously – giving the company or its shares credit or blame for past performance.
Which is natural… and wrong.
Let's say I bought a house last year for $1m. When I go to sell it, the agent tells me that it's worth $500,000 today.
Maybe the house is objectively 50% worse than it used to be. But almost certainly not.
It's more likely that I overpaid a year ago, or that the market is offering too low a price today. That doesn't reflect on the house at all – it's about my actions and the market's moods.
Similarly, if the agent tells me that it's worth $1.5m, the house didn't get 50% better. Again, either I got a bargain, or the market is overexcited.
It's the same with businesses.
Woolworths Group Ltd (ASX: WOW) isn't a bad business just because the price falls.
AMP Ltd (ASX: AMP) isn't a great business just because the price rises.
Both things might be true. Or not.
Because all a share price tells you – especially in the short term – is what people think, and how that thinking has changed over time.
That might be based on changes to the business, but often not. In the short term, sentiment tends to take hold over fundamentals.
Which can be a risk, if you listen to the noise, or an opportunity, if you think independently.
Remember, as Warren Buffett said:
"… like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence."
Which is appropriate… because the company I mentioned at the top is Buffett's own Berkshire Hathaway (in which I own shares, for the record)!
Fool on!
