Ignoring Price Swings Makes You a Better Investor

Last week's 10% drop in the value of the stock market should give you a reason to ponder the difference between the price and the value of your investments.

Most investors get in trouble when they focus too much on price. If you react to price swings, you're likely to be overexposed to risky assets when prices are high and underexposed to better values when prices are low. Why? Because a high price doesn't always mean the asset is worth the price paid, and a low price doesn't always mean the asset won't be worth more than what's paid.

Consider this. What if last week's 10% decline happened at 3:50 pm on Friday, instead of in the middle of the day on Thursday (when it had time to recover). When you went to check your 401(k) plan on Friday evening, you'd have seen that the value of your stocks was 10% lower than it was the day before. Then you'd get to stew on that number all weekend.

But was it really worth 10% less? Is it possible that the value of all these global companies dropped 10% in ten minutes? You of course know the answer to this question. No, the price didn't reflect the value of either the market or the companies that were most severely affected. This is an extreme example of how price and value can deviate. Yet lots of investors sold securities during that huge price decline.

Now consider the following data. In early 2000, the price of the S&P 500 stock index was about 1,500, and the earnings reported by all the companies in the S&P 500 were about $48 a share. Today, the price of the S&P 500 stock index is about 1,165, and the earnings for the companies in the S&P 500 for 2009 were about $51 a share. And estimates for 2010 are upwards of $65 a share.

So we actually have more earnings (more economic value) in the market today, yet the price is about 23% below where it was in 2000. Moreover, the dividends paid per share (actual cash paid to investors) was $16.70 per share in 2000 and last year it was $22.41. You're actually getting 35% more in cash for holding the same asset, yet the price is 23% lower. Does that make any sense?

The problem with focusing on price is that price can swing wildly for the same asset depending on investor sentiment. In 2000, people were enthusiastic about the future and simply willing to pay more for what they owned. This is the same thing that happened to the housing market between 2000 and 2007; people simply paid more for the same house than they did a few years before.

Now in 2010, we're all pessimistic (or maybe more realistic) and won't pay as much for any of these assets. So is there a better way to measure value than price? Well, this is a topic of huge debate in finance. As it turns out, market prices tend to be the best measure, but they still aren't very accurate. Prices for the exact same asset can swing 25% to 50% depending on how investors feel, and that's about as much as can be said. Thus, you shouldn't get so worked up over price.

The reality is that the stock market has more value today than it did in 2000. I don't know if that means it's fairly valued, but the companies produce more earnings and deliver more cash to investors than they did 10 years ago. That's a good thing.

Assuming that trend continues, while price may swing wildly at times, keep your eye on the economic value being produced by these firms. If it continues to trend forward, the odds are the price will at some point begin to reflect the better value in these holdings.

If you don't believe that earnings and dividends will increase for publicly traded companies, then there's probably no reason for you to invest. If you do believe it, then it's healthier to ignore the violent price swings, and think about the long term value that's being created by these firms.

Yet most investors have no idea what the earnings are on the S&P 500 or how much is being paid in dividends. You might be better off studying those numbers instead of following the price swings in the index.

Bottom line. Price and value can deviate depending on investor attitudes. But if you focus on economic value, you may have more confidence in the long term prospects of what you own.

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