Three Simple Analogies That Describe What Investing In the Stock Market Is All About

Analogies are often used to help explain complex things in a more engaging and simple manner. The same thing can work in finance and investing as well. The following are three simple analogies given by great investors that help to demystify what investing in the stock market is all about. Here goes!

Ralph Wanger:

“[There’s] an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.

But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the [dog watchers], big and small, seem to have their eye on the dog, and not the owner.”

The dog here refers to the daily movement of a company’s share price; the owner to the company’s business; and the dog watchers to well, investors.

In the 10-plus years since the start of 2005, Global Yellow Pages Limited (SGX: Y07) had spent 32.8% of all trading days with losses; for the same length of time, the ratio for Raffles Medical Group Limited (SGX: R01) was 38.5%. Seems like the latter’s going to be a poor investment right?

Global Yellow Pages and Raffles Medical's business and share price history

Source: S&P Capital IQ

Turns out, anyone who had focused on both firms’ daily short-term movements would have truly missed the forest for the trees. As Raffles Medical Group’s business (the owner) quintupled its profit over the past decade, its share price (the dog) eventually went on for the ride. The same can be said for Global Yellow Pages – except that the dog’s owner was on a steep downhill course!

Jeremy Grantham:

“Think of yourself standing on the corner of a high building in a hurricane with a bag of feathers. Throw the feathers in the air. You don’t know much about those feathers. You don’t know how high they will go. You don’t know how far they will go. Above all, you don’t know how long they will stay up…

… Yet you know one thing with absolute certainty: eventually on some unknown flight path, at an unknown time, at an unknown location, the feathers will hit the ground, absolutely guaranteed. There are situations where you absolutely know the outcome of a long-term interval, though you absolutely cannot know the short-term time periods in between. That is almost perfectly analogous to the stock market.”

As paradoxical as it sounds, it can be easier to make long-term predictions about the stock market than it is to do short-term ones. The chart below, which plots the Straits Times Index’s (SGX: ^STI) distribution of returns in each calendar year from 1988 to 2013, illustrates this well:

Return distribution for Straits Times Index

Source: S&P Capital IQ

Over those 26 full calendar years, Singapore’s market barometer has seen four years where it has lost 20% or more and six years where it has gained 20% or more. With such wild returns each year, it’s hard to tell what the index will do in any given year.

But if you had thought back in 1988 that businesses in Singapore will become ever more profitable as we progress from one decade to the next without worrying about the wiggles in between, you’d have done fine: Since the start of 1988, the index has more than tripled from 834 points to nearly 3,400 today.

Dean Williams:

“What I have to tell you tonight is that [investing] is a lot more like quantum physics than it is like Newtonian physics. There’s just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”

In Newtonian physics, the laws of nature are neat and orderly. You can calculate the effects that gravity and air resistance will have on a falling ball with precision; you can even know how high it will bounce up to after it first lands. Heck, you can even calculate how fast and what angle a rocket needs to fly from Earth in order for it to land on a moving comet.

In quantum physics though – which are the laws of nature that governs things at the atomic or sub-atomic level – things are messier. Far messier. For instance, you can’t even pinpoint if a certain particle is even there; all you can know is that there’s a low or high chance that it might be there. Also, the act of measuring something in itself can change the thing you’re trying to probe.

The world of finance and investing is very much like quantum physics. What looks intuitively predictable – like how a strong economy would result in great stock market returns – doesn’t always work:

So what this analogy – that the stock market is more akin to the messy quantum physics than to the orderly Newtonian physics – really means is that predictions are incredibly tough to make in the world of finance and investing.

Fortunately, we don’t have to depend on accurate forecasts to invest well. As the great investor Benjamin Graham once said, “The purpose of the margin of safety is to render the forecast unnecessary.” If we give our investing activities enough room for error, we can still profit even if things didn’t necessarily proceed in the way we imagined they would.

A Fool’s take

So, pulling everything together, what these three analogies are trying to tell us is that, (1) we should always focus on the long-term progress of a share’s business; (2) bet on long-term outcomes instead of short-term ones; and (3) leave forecasting alone and instead, invest with a large room for error.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Raffles Medical Group.