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What You Really Buy When You Buy Stock Investments

What You Really Buy When You Buy Stock Investments

April 30, 2020

And Why Many Investors Overestimate The Impact of Short Term Events

A few weeks ago, when the stock market was collapsing and people were panicking, I wrote that all would eventually be ok.  That the market was overreacting.  And even if markets kept going overreacting, this pandemic event would run its course, though I didn’t know how long that would take) and we would get back to business.  People were focusing too intently on an admittedly very bleak short term outlook, I suggested, while the long term picture wasn’t all that bad.  Moreover, I said, investors should be focusing on their financial plan (which is long term in nature) and not on this short term event. 

Within a few weeks, although we are decidedly NOT back to business as usual, the market has recovered a lot of the ground it lost in those ugly days.  We still have a ways to go, and markets are still quite volatile, but the panic is largely gone.   

Now many folks are wondering how the market can rally so strongly when there is still so much uncertainty out there.  We still don’t know when people will get back to work, or what will happen with the virus when they do.  I admit to having had my own doubts the last few days.

The thing is, markets don’t set prices the way most investors think they do.  People like to lay outsized importance on recent events. So when it became evident we were going to have a serious and prolonged economic event, many investors first reaction was OH MY GOD WE ARE GOING INTO A RECESSION I HAVE TO GET OUT OF STOCKS BEFORE I LOSE ALL MY MONEY!  People suppose (especially if they spend too much time watching CNBC or Fox Business) that the price of stocks is determined largely by what is happening now, or what will be happening over the next few months.   And while the next few months matter, they do not matter as much as you might think.  The reason is found in the very fundamental basis of what you buy when you buy a stock.  

This is something most casual investors don’t think much about, but when you buy a stock, lets say Coca Cola, you are buying a share of all the future profits that Coca Cola will ever earn.  As in FOREVER.  That is really all a stock is.  The price is a function of what people are willing to pay TODAY for all those profits stretching off into the future. Prices change as the markets assessment of those future profits change.  Even If the COVID 19 shutdown causes Coke profits to collapse for the next 12 months because people aren’t going to restaurants or convenience stores – that still leaves profits for 2021 and on into the future untouched (assuming this thing doesn’t go on forever and people are still addicted to sickly sweetened soft drinks!).  So as some of the emotion came off and the shock wore off, investors just figured they had gone too far with the selloff and prices bounced back nicely. 

Now I shouldn’t downplay the potential significance of the next 12 months too much. It is certainly possible that near term events COULD impact profits off into the distant future.  For instance, as the crisis drags on, many marginal firms (restaurants, airlines, travel) in impacted industries may go bankrupt, making their stocks worthless. If a firm goes bankrupt, then there are no future profits to buy and a stock price of course becomes 0.   Indeed the stocks of these impacted companies have suffered disproportionately, showing the market is being quite discriminating.  Losses from bankruptcies of impacted firms could impact many other firms and perhaps the banks or finance companies who lend to them. Individuals could find themselves in really bad financial straits and be unable to spend like they used to.  Defaults on consumer loans could hurt banks and finance companies.  So there is still a lot of uncertainty out there, and will we work this crisis out.

Fortunately for investors in broadly diverisifed mutual funds, these highly impacted companies and industries make up only a very small share of the overall stock market, so whe the market AS A WHOLE looks into the future, it sees a brighter future.  

The primary lesson here is not to get too caught up in the short term forecasting game.  It is all well and good to wonder what is going to happen next, and to listen to talking heads spew their opinions on TV, but a) no matter their credentials, no one is very good at predicting the future anyway and b) regardless of whether they are right or wrong about the next 6 to 12 months, I think Coca Cola (and most of the rest of corporate America) will find a way to be making plenty of money 5, 10, and 15 years from now.   And except for brief periods of panic such as last month, that is what the stock market will always come back to focus on.