The current drama unfolding in the Chinese stock market – the Shanghai Stock Exchange Composite Index had fallen by as much as a third earlier this month from a peak of more than 5,000 points in mid-June, prompting Chinese authorities to introduce a wide array of measures to prop up stock prices – is a harsh reminder to many of the dangers inherent in the stock market.
But, what it really is though, is a reminder of how investors can take advantage of the market.
The nature of the beast
The stock market, at its core, is just a platform for people who want to sell their ownership stakes in companies to connect with people who are interested in buying them. It’s supposed to be dispassionate. But since people are the ones making the buying and selling decisions, emotions inevitably come into the fray.
In the stock market, the most significant emotions are that of greed and fear. The volatility in the Chinese stock market seen so far this year can be a good example.
Locally, the breathtaking boom and subsequent stomach-churning bust of the infamous penny stock trio of Blumont Group Ltd (SGX: A33), Attilan Group Ltd (SGX: 5ET) (what was then known as Asiasons Capital), and LionGold Corp Ltd (SGX: A78) back in October 2013 can also be a great case of how the two emotions can wreak havoc in the market.
Keeping your wits about you
But, just because the market is subjected to greed and fear – which helps create the boom-bust cycle – does not mean that as prudent and intelligent investors, we have to be sucked into that speculative and emotional world. There is another way for us to think about the stock market, and it is how we can take advantage of it.
The late Benjamin Graham was the one who introduced the allegory of Mr. Market. Graham thinks that you can liken the stock market to be the character of Mr. Market, a maniac-depressive business partner of yours who knocks on your day each day wanting to buy your stocks or sell you his.
Mr. Market’s maniac-depressive nature results in days when he’s willing to sell you his wares at dirt-cheap prices. Meanwhile in other days, the stocks he wants to sell can be priced exorbitantly.
His emotional instability also leads to the same type of dynamic when he’s trying to buy your stocks. There are days when the prices he’s offering are so low they don’t make sense; then, there are also times when he’d be happy to buy your stocks from you at prices beyond your wildest dreams.
This character trait that Mr. Market has is something we can take advantage of if we adhere to two reeds. First, we must be able to be greedy when he is fearful and fearful when he is greedy. Second, we must be able to figure out the underlying economic value of the companies that are listed in the market as that’s the only way we can know if the prices that Mr. Market’s throwing at us makes sense or not.
The boom-and-bust nature of the stock market will likely always exist. But we need not fear the volatility as individual investors – all we need to do is to understand the nature of the market and we might then be able to take advantage of Mr. Market when he’s overwhelmed by either greed or fear.
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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 Stanley Lim does not own shares in any companies mentioned above.