Something is desperately wrong with today’s stock market investors.

Discover the insanity in the stock market

The facts clearly show that otherwise intelligent people, brimming with common sense and wisdom in other areas of their lives, suddenly lose their logic when it comes to the stock market.

Many don’t know how much they are paying for their mutual funds – some even believe their funds are being managed for free or their investment advisors are not charging them anything and simply providing advice as a favor.

Seriously. I’m not making this up.

Others lose sight of the fact the stock market is made up of individual companies, not simply slips of paper or disembodied numbers floating across computer screens.

It’s easy to see why. Wall Street has a habit of hiding information from Main Street. You never receive a bill in the mail telling you how much was deducted from your mutual fund account for fees and other costs. These are simply deducted before you receive your statement.

And most people don’t realize how the stock market really works. They may have a vague idea the “hot” ticker symbol they just heard about is related to some distant company, but to them, it’s simply numbers. Buy at a certain number and hope to sell at a higher one.

So let’s clear up at least one of these issues. Today I’m going to talk about the stock market.

When you purchase shares, you’re actually purchasing a piece of a real company. Yes, it’s a very tiny piece, but it’s a piece nonetheless. This makes you a part owner.

What you own is as real and tangible as if you purchased a stereo system or an ice cream cone or a horse. If you understand this concept, then you’re already ahead of many others who are investing willy-nilly in the stock market.

Why?

Because you will then understand that, in the long run, a stock’s price depends on its underlying business. In the short-term the business’s results and its stock price can diverge – sometimes widely – but in the long-term, both tend to reflect the same thing.

A business’s results, as measured by earnings growth, is the main driver for its long-term stock price.

So if a business grows its profits by 10 times over 25 years (a 9.65% annual return), we could reasonably expect its stock price to behave similarly.

Of course we’re talking about good, solid businesses with predictable earnings and strong moats. If you’re looking at penny stocks or their speculative cousins, then all bets are off.

However companies such as Coca Cola, IBM and Microsoft tend to have stock prices that correlate well with their profits over long periods of time.

On the other hand, if you’re looking at shorter timeframes, stock prices can be all over the map and not reflect profits in any meaningful way. Unfortunately most people look at the stock market through the lens of a short-term player. They listen to the latest news and hot tips or believe what the so-called, “expert” analysts have to say. And they base their buying and selling decisions on these short-term inputs.

However it’s exactly this short-term thinking that is usually the cause of most stock market losses.

If you really think about it, it’s insane to try to predict what will happen in the next day or week or month or even, perhaps, year. Nobody can successfully and consistently predict the market. Yet many people try.

To see the absurdity of this, let’s look at an example.

Suppose I’ve just picked up a red 2014 Ferrari LaFerrari (I know, silly sounding name, but quite the car). The LaFerrari’s 6.3 Liter V12 produces 800hp at 9,000 RPM and allows the car to accelerate to 100 km/h in less than 3 seconds! Its top speed is in excess of 350 km/h (that’s about 217 mph for the non-metric crowd).

Obviously this car can move quickly.

However suppose I only drive it in rush hour traffic where its speed is constrained by other vehicles. If traffic is moving at an average speed of 50 km/h, anyone watching would realize the LaFerrari will take about an hour to drive 50 kilometers.

Sure, I could speed up when a gap appears or I might get stuck behind a truck and lag behind for awhile, but ultimately LaFerrari cannot cover the distance any faster because it’s constrained by the slow moving traffic.

Now let’s say we open a betting shop for clueless gamblers and allow them to bet on how fast LaFerrari will cover the 50 km distance. The faster the car covers the distance, the bigger the payoff — if they get it right.

Knowing the specifications of the car, some will do a quick calculation and come to the conclusion that because the car’s top speed is 350 km/h, it will cover 50 kilometers in less than 9 minutes.

Others will realize the car can’t always move at its top speed, because of the intervening traffic, but will nonetheless see it accelerate into a gap, say reaching 100 km/h, and bet it will sprint off into the distance at 100 km/h, maintain that speed and thus cover the distance in about 30 minutes.

Of course neither of these bets will pay off because the car will eventually have to slow down and move at the average speed of traffic – which is 50 km/h. Therefore it will take LaFerrari about one hour to drive the distance.

But our deficient gamblers don’t think about that. They ignore the average speed of traffic and place bets that the car will maintain its higher speed over the long term. Although it should be plain the car cannot exceed the average speed of traffic, greed and emotions cause the gamblers to overlook this and take a very short-term view on what will happen in the long run based on what is currently happening right now.

Nobody would be that daft right?

Well, this same sort of thing is happening every day in the stock market.

If an, “expert-guru-super-analyst” says something good about a company on TV, many times that company’s stock’s price will jump significantly – far outpacing its underlying fundamentals. This might continue for a few months or a few years. Eventually, however, it will have to wait for the business’s earnings to catch up or, most likely, fall back precipitously in a very short time.

Think about it.

It’s exactly the same concept as the LaFerrari scenario. However nobody in their right mind would take the bet on LaFerrari covering the 50 km distance in significantly less time than an hour, yet just about everybody will take the bet on the latest hot stock continuing its meteoric rise.

If you want to see examples, look no further than the dot com boom at the turn of the century. Even if you eliminate the terrible companies that had no hope of making a profit, there were still excellent companies around that were horribly overpriced.

Eventually even these solid companies’ stock prices, which had far outpaced their underlying earnings, had to crash back to Earth. And they did. And it wasn’t pretty. And people lost lots of money. And that’s why most people will never be able to afford a car like LaFerrari. Ever.

Yes, something is desperately wrong with today’s stock market investors.

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