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3 Analogies To Simplify What The Stock Market And Investing Is 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 analogies given by great investors that help to simplify what the stock market and investing is all about.

Ralph Wagner:

“[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.”

Over the 10 years ended 8 February 2017, SembCorp Industries Limited (SGX: U96) had seen its shares fall on 44% of all trading days; for the same length of time, the self-same percentage for Raffles Medical Group Ltd (SGX: BSL) was 41%. Seems like the latter’s going to be as bad an investment as the former, right?

Sembcorp Industries and Raffles Medical table
Source: S&P Global Market Intelligence

Turns out, anyone who had focused on both firms’ short-term movements would have truly missed the forest for the trees. As Raffles Medical’s business nearly tripled its profit (the dog owner) over the past decade, its share price (the dog) ended up at a similar destination. The same can be said for SembCorp Industries – except that the dog owner was on a 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.

Shiller PE for 1-year and 10-year holding periods
Source: Robert Shiller’s data; author’s calculations

The two charts above use US stock market data from 1871 to 2014 and they compare the annual returns of the S&P 500 against the index’s starting valuation for a holding period of 1 year and 10 years.

With a 1 year holding period, the stock market is essentially a crap shoot; cheap shares can easily fall and become cheaper while expensive shares could just as likely go roaring on and become even pricier.

But when we extend the holding period to a decade, a much clearer theme emerges: Buy stocks when they’re cheap and you’d likely end up with a good outcome; buy them when they’re pricey, and you’d have poor odds of turning in a profit.

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 tidy. 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 long it would take for a spacecraft to travel from Earth to Pluto – a distance of nearly five billion kilometres – with near perfect precision. (NASA’s New Horizons spacecraft was launched in January 2006 and reached Pluto in July 2015. The entire journey “took about one minute less than predicted when the craft was launched,” according to NASA.)

But in quantum physics – 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 at a physical spot; 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. Take a look at the tweet below from investment manager Ben Carlson. It shows the economic growth and stock market returns for China and Mexico over the 22 years ended 2013.

There are other good examples.

The lowest price WTI Crude Oil reached in 2016 was US$26.61 per barrel and that was reached on 11 February. Slightly over 10 months later on 21 December 2016, WTI Crude Oil had doubled to a price of US$53.53.

But over the same period, a collection of 50 Singapore-listed oil & gas companies had seen their stock prices decline by 11.9% on average. And within that group of 50, 34 of them actually had saw their stock prices fall in the timeframe we’re observing.

The aforementioned 50 names may not be a complete list of all the oil & gas-related companies listed in Singapore. But, I think they are a representative group, considering that:

So, what the analogy that Williams brought up – that the stock market is more akin to the messy world of quantum physics than to the orderly universe of 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 fail to 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 stock’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. The Motley Fool Singapore has recommended shares of Raffles Medical Group. Motley Fool Singapore writer Chong Ser Jing owns shares in Raffles Medical Group and Keppel Corporation.