“Enlightenment is found not in the monastery, but the marketplace.” Mountaintops are peaceful as if made for calm. But it is the chaos of the marketplace which reveals character. Trekking into the storm requires principles, market values, for deft maneuvering.
Markets test our ability, emotional capacity, and reactivity. Because of this, they are a fantastic reflection. Markets have a way of pushing people to the limits of their ability and exposing the best-hidden weaknesses. When a student skips homework, they receive a poor grade on the assignment. When a participant doesn’t do the work before venturing into the market, it has a way of exploiting their weakest point in teaching its lesson. Does that sound like a microcosm of life?
There are three things to know before entering a market. My market values: 1) how it works, 2) strengths and weaknesses, and 3) how that applies to the current environment.
Market Values to Build On
Understanding is the foundation of success. If you do not know how something works, how will you know how to use it properly, what the effects will be, or what the markers of success should be?
Strengths and weaknesses are essential to identify and come from an awareness of how something works. Knowing what something does well and poorly builds use and avoidance cases. A knife is great for opening boxes but terrible for a gunfight. Strengths and weaknesses extend to success or failure.
The current environment dictates performance. If a tree produces delicious fruit, lives long, and needs little care but needs lots of water, don’t plant it in drought conditions. Despite that tree’s positive qualities, during a drought, plant something that thrives on heat and little water. Choose the best option for the environment instead of the best option.
These market values are applied to select assets below. This post describes their mechanics, strengths and weaknesses, and current situation. Let me know how I did in the comments below the post.
Stocks for Sale!
Stock is equity in the company which issued it. It means being a partial owner of the business. Shares of stock are bought and sold on stock markets. Owning stock is owning a portion of the underlying company.
The stock market functions similar to the trading of cards. For example, a seller offers a Michael Jordan card for $10. The Michael Jordan card is worth $15 to a buyer, so it is purchased. Later, another buyer wants a Michael Jordan card and offers to pay $20. Since the current holder values the card at $15, the card is sold for $20 to the second buyer for a $10 profit ($20 sold for less $10 spent) ‘trading’ the card. Replace the Michael Jordan card with a share of stock and the underlying mechanics hold.
Stocks track the underlying business value. Investors value a company in various ways, but shares also trade on hype, fear, and speculation. A stock is worth what someone is willing to pay for it. Similar to the Michael Jordan card, there is no correct value, and investors may be willing to pay different amounts for the same stock.
Stock Up?
Stocks have produced the best rate of return. Investment in U.S. stocks is a position that American business will prosper. Stocks are investment darlings because they have been the best performing asset. Warren Buffet said: The economy, as measured by gross domestic product, can be expected to grow at an annual rate of about 3 percent over the long term, and inflation of 2 percent would push nominal GDP growth to 5 percent. Stocks will probably rise at about that rate, and dividend payments will boost total returns to 6 percent to 7 percent.
Stocks can decrease in value, be volatile, and be challenging psychologically. Share prices can go down and result in a loss of all or a portion of the original investment. Stock prices fluctuate up and down over periods of different durations. Price movements and the potential for losing money are stressful. Utilizing market values and having a strategy will help navigate emotions when stock prices fluctuate.
In Stock
Stocks produce the best historical returns. Business leads the world forward. Equity ownership in the companies that solve the challenges the world faces will prove as valuable as ever.
Valuation matters. Stocks are trading at or near all-time highs despite a catastrophic economic environment. For example, the dot com bubble saw shares trading at levels that did not generate historical returns. As recently as 2010, stock prices were flat or lower than they had been ten years prior. They have the best performance over a long period, but that time horizon may take decades to realize. The stock market operates independent of the economy, but the businesses it represents ownership in do not.
Bond-ing
Bonds are money lent from an investor to a borrower. They are debt that a business or government borrows. The entity that receives the money is the issuer of debt, while the provider of capital is the bondholder. If a local government issues $10,000 of bonds for a new park, investors provide that entity $10,000 in loans.
Owning the debt earns income in the form of interest. That interest is income for the bondholder. For example, if the bond issued to fund the park pays 5% interest, the bondholders will make $500 in interest per year.
Interest rates impact bond value. Issuers pay a fixed amount on the debt. As debt trades, new buyers may require an interest rate higher or lower than the amount the bond provides. In other words, the price bonds trade at will change so that investors receive their expected yield. Investors requiring different interest rates and paying a different price for the fixed income stream does not impact the payment terms of the issuer.
A Strong Bond or Weak Bond
The interest payments and repayment of principal at maturity make bonds ideal for generating consistent cash flow and protecting investment value. Bonds purchased with the intent to collect the interest until it matures achieve that. For those without volatility tolerance, such as in or near retirement, bonds are an ideal investment.
Bonds decrease in value if interest rates rise, are subject to credit risk, and have underperformed stocks. When rates rise, bonds decline in price as a function of the increased interest rate expected from them. Money lent is subject to the entity that borrowed being able to repay it. Owning equity has produced better returns than holding the debt.
Bonded Today
Bonds offer a fixed income stream with repayment at maturity. Principal preservation, while generating a return, is where debt excels. If holding debt until it comes due and the interest income provided is acceptable, they are a reliable option.
The interest rate to borrow money is at historic lows, while debt and risk are high. That position presents a precarious situation for bondholders. If rates go up, that is great for future savers but decreases the price a bond can sell for before its maturity.
Golden Values
Gold is a physical asset that functions as a store of value. It is a commodity; one bar of the precious metal is the same as another. Jewelry, decorative items, and coins all use gold. Also, the supply of gold is relatively fixed. The amount mined doesn’t increase how much gold exists in a meaningful way. The uses and finite amount make gold an attractive store of value.
Gold functions differently than stocks or bonds. It is tricky because it is a physical asset. Purchasing physical gold means transporting it and storing it. Do you have anywhere to put quantities of gold bullion? The way for most investors to gain exposure is through gold exchange-traded funds (ETF). For instance, Gold ETFs trade on stock exchanges. Instead of owning a business, the shares of ETFs own and store gold.
Does Gold Always Glitter?
Gold functions well in times of crisis. When things aren’t going well, and investors are searching for a haven to preserve wealth, gold is the best option to store that value. The purchasing power of gold is resilient. For this reason, it performs well when the money supply expands, which decreases the purchasing power of money.
Gold generates no return. Bonds or cash in a savings account provide some return on capital. Gold sits and doesn’t generate income on its own. Gold is subject to the price someone is willing to pay for it.
Stay golden?
Gold performs well in times of crisis. In particular, where investors want to preserve purchasing power. While it doesn’t create wealth on its own, if investors want to reduce risk and flee to safety, gold is a haven. The increased demand drives gold prices up.
Gold produces less income than bonds or savings accounts, and stocks have outperformed it. Even with historically low rates for debt and savings accounts, they provide a better income stream than gold does. Additionally, the U.S. and others have outlawed ownership of gold in the past during times of crisis.
Cash Money
Cash is available money. It is the medium through which transactions occur. Cash purchases stocks, bonds, or other assets. It pays for expenses. Funds in a savings account, held in a money market, or under the mattress are all cash.
Cash exchanges for goods and services. It acts as a store of value. The barter system converted into currency and hasn’t looked back. Money provides an efficient medium of exchange. Other assets express their value in cash.
Cash Only
Cash allows optionality. It is advisable to have some money on hand at all times. If unexpected expenses arise, funds on hand are needed to pay. If you decide to purchase stock, bonds, or other financial assets, cash facilitates it.
Cash produces no return. After accounting for inflation, it loses purchasing power. Savings accounts provide only minimal interest and don’t build wealth. Having cash on hand is the least exciting investment option. Investors keep it until they find a buying opportunity.
Cash, in this Economy?
The value of optionality increases with uncertainty. Cash on hand provides flexibility to purchase undervalued assets, pay expenses when income decreases or stops altogether, or hold tight and wait for a better opportunity. Buying low to sell high is not possible without cash to do the buying.
Cash is for spending. In a system flush with cash, opportunities vanish quickly. Returns available to those holding cash can decline so that what money buys tomorrow produces less than today. With the Fed showing an appetite to contribute money to the system, its purchasing power could decline
Lasting Market Values
Market values are guideposts to provide direction. Three pillars proven sturdy for me are understanding, benefits and drawbacks, and applications in the current context. Market values are the roots that grow success.
In any market, there are two primary strategies to employ. Investors adjust them to fit what they are trying to accomplish and their particular risk tolerance.
Be aggressive. When asset prices jump around, plow forward. Buy stocks and know that the average historical return is favorable. Continue to put money to work in the stock market in whatever interval possible and don’t pay attention to market movements.
Be conservative. Capital preservation is as or more important than maximizing returns. Preserve wealth and play defense until able to go on the offensive.
Bulls make money. Bears make money. Acting without market values puts you in the cage with both.
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