Price vs. Value

Jonathan Clements  |  January 13, 2018

WE CAN THINK OF INVESTING as an argument between two competing opinions: What we think an investment ought to be worth—and what the market currently says. It’s an argument the market usually wins.

While we can be highly confident what, say, a certificate of deposit or a Treasury note is worth, it’s much harder to put a value on stocks, gold, high-yield junk bonds and other riskier investments (and, I’d argue, all but impossible with bitcoin). Even most money managers, who devote their professional lives to scouring the markets, aren’t skilled enough at spotting undervalued investments to overcome the investment costs they incur and the management fees they charge, and thereby deliver market-beating returns.

That’s why I start by assuming that the current price for stocks, bonds and other securities is probably pretty close to the fundamental value for these investments. I don’t subscribe to the extreme version of the efficient market hypothesis, which says securities are always correctly priced. But I do believe that the market is sufficiently efficient that it’s extraordinarily difficult for investors to earn market-beating returns over the long run, and thus most of us should steer clear of picking individual stocks and buying actively managed funds, and instead purchase market-tracking index funds.

This conflating of price and value, however, has its dangers. If investors assume price equals value, they may become overly enthusiastic about stocks during bull markets—and overly pessimistic during market declines.

Cast your mind back to March 2009, when the S&P 500 was 57% below its October 2007 high. If you had bought a collection of stocks for $1,000, and now honestly believed that their true value was just $430, dumping your holdings wouldn’t be an unreasonable response. After all, given the shocking loss of value in just 18 months, who knows what your shares might be worth if you stuck with them for another few months? But selling in March 2009 would, of course, have been a terrible mistake—which is why we need some sense of stocks’ value that is distinct from their price.

Even bull markets, like the one we’ve enjoyed for the past nine years, can be dangerous. If investors assume that stocks are just as good value today as they were in early 2009, they may allocate more to stocks than they can reasonably stomach, without appreciating the potential downside.

What to do? My advice: Imagine a line climbing steadily at 6% a year, with 2% from dividends and 4% from share price appreciation, as stocks rise along with 4% growth in earnings per share. That’s my expectation for the long-run return from a globally diversified stock portfolio.

Stocks will vary from this 6% line, as investors’ enthusiasm waxes and wanes. When stocks earn less than that 6% in a year, I assume we’ll see catching up at some point in the future and that my tenacity will eventually be rewarded. What happens if stocks race ahead of that 6%, as they did in 2017? I assume we’re likely borrowing gains from the future. Even as I admire my fattened portfolio, I brace myself for lower returns in the years ahead—and do a little rebalancing.

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