March 3, 2008 | posted by Michael Baxter in Markets |

There’s a theory that you can’t make money from shares, because all the information that is available on a specific company is allowed for in its share price.

When a company is valued by the markets, this is what economic theory says happens: analysts work out the future dividend stream of that company, based on all information legally available, then from that expected future revenue stream, calculate a net current value by discounting future income against a rate of interest.

Not all analysts will agree on the correct current value, but as they trade with each other, a market price will be determined which is in effect an average of these different calculations.

So, why have faith in this market price? Well, consider the ‘guess the weight of the turkey’ competition at a fair. Some people’s guess might be too high, others, too low, but usually the average of those guesses is pretty much spot on. There has been a wealth of research to prove exactly that point.

So, apply that principle to the markets valuing a stock, then the share price determined by the markets must be just right. This has an important implication: if this theory is right, then, frankly, investing in shares is a mug’s game. There is no point.

There are many reasons why the theory is probably wrong. Here are two:

First you have the herd instinct. We saw during the days of the dotcom boom, traders were scared to go against the pack. In one of their quieter moments, at home perhaps, all alone, listening to their favourite album, then a trader may have feared shares had gone too high and were in for a fall.

But then, the next day, in the jungle of trading, the terrible truth would dawn. They would not dare go against the pack, for this simple reason. If they were wrong, and they sold while others profited, they would probably lose their job. If on the other hand, they bought when shares were too high, and then took a loss, well, at least everyone else was making the same mistake – their, job, for the short-term at least, would still be safe.

But perhaps there is an even-deeper force at work here.

It’s the bull and bear relationship. The history of economics tells us business suffers from periods of over-exuberance, followed by the complete opposite. The dotcom boom and crash is the perfect example, one moment shares were pushing beyond the stratosphere, the next, no one wanted to even hear the word dotcom.

Traders’ mood went from arch bull to arch bear, virtually overnight. The fundamentals had not changed, rather, there was a change in mood. In a boom market, people buy for no better reason than shares had risen the day before, therefore, they would probably go up the next day.

For the investor this is good news, because it means that if you take a longer-term view on things, sit back and look with cold eyes, you can ignore the ups and downs, and just focus on underlying value, and growth prospects. Your estimate of net current value may well be far more accurate than the market price.

Another example of why this is so, came last week, as markets rose on bad news, and then did a mini collapse, when reason dawned. The markets were irrational – completely, and for the investors whose feet are firmly on the ground, that means opportunity.

And to find out what happened last week, read the next article, below.