The Stock Market Is Like a Wave, Kind Of - ToughNickel - Money
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The Stock Market Is Like a Wave, Kind Of

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

the-stock-market-is-like-a-wave-kind-of

The Stock Market is Like the Ocean

Investing titan Warren Buffett has famously said, "when the tide goes out, you find out who's been swimming naked." My source for this is having read all of his letters to shareholders for both Berkshire Hathaway and Buffett Partners Limited, BRK's predecessor. As usual, Buffett uses folk wisdom here to point to a very apt analogy: the ocean and its tides are like the stock market, insofar as there is a mass of water (liquidity and capital) that ebbs and flows, much like the tide. "A rising tide lifts all boats" might be a little bit less eloquent, but certainly also applies: when the stock market is rising, most individual stocks also rise, largely due to wealth effects and investor psychology. If you'll bear with me while I further overuse and butcher the stock-market-as-an-ocean analogy, I'll give you four distinct metaphors you can use to better understand investing, and how to formulate your strategy for both investing and trading. For the purposes of this article, I'll assume you're more of a value investor like me, with lots of businesses in your portfolio you wouldn't necessarily mind holding forever... unless, of course, the right price comes along.

the-stock-market-is-like-a-wave-kind-of

Individual Businesses are Dolphins

That's right: dolphins. Individual businesses you own are going to have a sort of mind of their own in terms of stock prices, bobbing up and down along the surface of the water, but sometimes diving down pretty deeply, plunging to depths you hadn't previously thought possible. Yikes! On occasion, however, a dolphin will unexpectedly (or expectedly, if you really understand marine mammals) leap above the surface of the water. Sometimes a stock will leap up above its intrinsic value, and that's the time to sell. If you're following a stock and it dives below its intrinsic value, that's the time to buy. Clearly, you need to understand what the intrinsic value of the stock is in the first place, and I'll have to leave that to you for now (but please read Buffett's letters to shareholders, or Poor Charlie's Almanack, if you can find a copy, to help understand these concepts). Watch out for these individual stocks bobbing up or down, and if the irrationality of Mr Market tells you it's a good time to sell, go for it.

Today's Market Cycle is a Wave

Waves lift the surface of the ocean water up and down with predictable regularity, and while the market on a given day can be somewhat irregular, there is generally a trend in one direction or the other (bull or bear) for a significant portion of the day, and sometimes for the entire day. This relatively brief run can and does lift many stocks up if it's rising, and drops 'em down if it's falling. If you have a reasonably well diversified portfolio of individual securities, you'll generally see 75% or so of them moving in tandem with this wave. This can be really useful information to consider if you happen to have a dolphin hopping up at the same time as a wave cresting; and, of course, the inverse is true.

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The Bull/Bear Market Cycle is The Tide Going in or Out

Although the time frame of the cycle of the tides coming in and going out is about 24 hours total, and the market takes anywhere from 5 to 15 years to complete a full cycle, give or take a few years; the tide going in or out is an incredibly apt analogy for the ebb and flow of the market. Howard Marks is like a wonderful broken record in his memos, pointing out for the eager student of investing that the one thing you can really count on with the markets is cycles. And while dolphins might generally be able to leap out of the water a meter or two, and a wave might crest a few feet higher, if the tide has gone out, the surface of the water is going to be quite a bit lower than it would be at high tide. This means that, on average, the tide is a more important factor than the daily market cycle. This is a trap I see investors and traders falling into frequently: a stock might dip 5% on a given day, and that seems like a time to buy. It certainly can be, but not if the same stock has been riding a "tide" (bull market) up 50% since you first started watching it. Naturally, this is where trading and investing start to diverge: a trader might be okay with the very short term dip, in the hopes that the stock might bounce back in the next day, week, or month, and if they're good at what they do, they'll probably be right more often than they're wrong. Nevertheless, if you're focused on longer term gains, consider the magnitude of the market over time as compared to the day-to-day gyrations. Now, if the rising tide happens to line up with a cresting wave and a leaping dolphin, you may have a great opportunity to sell (and, of course, the inverse is true).

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The All-Time Market is Global Warming

How about a more morbid analogy to close things out? The ocean levels are gradually rising due to climate change (in no small part due to the economic growth that has been accelerating rapidly for the last hundred years, appropriately enough), as icebergs that are on land melt and run off into the water. Coastal cities are already endangered in several spots, and the next half century looks like it'll bring us more of the same. In a similar manner, the stock market is an ocean with more and more water being added all the time. Study any chart of the Dow Jones Industrial Average, the S&P 500, or any index of a relatively comprehensive number of stocks, and you'll notice a very clear trend over time: exponential and steady growth. Any longer term investment strategy needs to take this into account, and it's the reason you'll often hear the phrase, "time in the market beats timing the market." The global warming of economic growth over time is as certain as the concept that, on average, sea levels will rise tremendously over the next century.

So What?

Here is where investing and trading philosophy come into play. Everyone's portfolio needs to be a little different, since every individual will have different needs and desires as to what they'll want from their stocks. While the global warming of economic growth that leads to a rising ocean level over time is inevitable, this doesn't mean you can't make money in the short and medium term by considering the ebb and flow of the tide coming in and going out, particularly if your time horizon is in the five to ten year range. None of this is to say that you can't time a jumping dolphin and a cresting wave if your time horizon is in the weeks or months. If, on the other hand, you can channel all four forces at varying times, your portfolio is almost certain to be dramatically improved, so long as you pick great businesses in the first place. If you do that, then you can always default to global warming and the inevitable conclusion that, eventually, the market and value of the business will have to align.

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This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.