Imagine buying a house for $1million. Friendly neighbourhood, low crime rates, reputable schools nearby. Keeps warm in the winters, cool in the summers. Spacious and well-maintained.
Tomorrow, if I quote you $900k for the house – would you accept?
What if the day after I come along and quote you $800k, would you now accept? I doubt it.
How about the day after that, I quote you $500k, would you say yes? I'm guessing no.
A week later, if I quote you $100k for the house, would you sell? You'd think I'm crazy!
Quotations of any sort would not unsettle the homeowner. Neither would they succeed in triggering a panic sale, nor in cementing the false belief that the house is becoming worthless. It's because you understand what you own.
Investing in stocks requires a similar mindset. They are ownership interests in a business - a share of its assets, liabilities and future earnings. Not just a number on a broker account, waiting to be traded within hours of purchase. Crucially, investors forget the market is there to serve, not advise.
When a stock falls from $100 to $90, then to $80 over the week, panic and uncertainty dominate over facts. As it hits $50, previously held positions have already been disposed. At $10, everyone's questioning whether it will go any lower? But why?
It's simple - investors don't understand what they own. It is common to own stocks in fancy tech companies, claiming the future, but unquestionably beyond many investors understanding. Especially recurrent is the tendency to invest plainly because the share price has risen over the past week, month or quarter. As protection from this ignorance, investors "diversify" and invest in 30 or so other companies they don't understand. There is now a false sense of security and a seemingly promising portfolio, which in reality is nothing short of a mystery. Thereby, when prices fall, from say $100 to $50, positions are sold arbitrarily, losses are realised, but lessons are not learnt. A week later, the same stock goes back to $100, and the sentiment is bullish again.
A strong understanding of the business, its financial position and a sole acknowledgement of the facts at any given moment, would lead the intelligent investor to buy and not sell in times of declining stock prices. The intelligent investor would distinguish facts from opinions to reach a sensible decision on whether the business has been materially affected. If there is no material change, the discounted share price presents a very lucrative opportunity.
Equally, the intelligent investor would dispose of entire positions in the event of an adverse material change to the business. Without an understanding of the business, trading on stock prices is merely a speculative operation - an affirmation of a disregard towards thorough analysis. Lack of certainty and knowledge of the investment drives one to sell when the price is down and buy when it's up.
No two businesses are the same. Nor are there 50 equally great investment opportunities present to the investor at any given time. The intelligent investor would select the best 1 or 2 companies and avoid diversifying into tens or hundreds of businesses they have little to no knowledge about. These modern diversification practices can prove successful in achieving average or below-average returns. Nonetheless, they are purely a hedge against ignorance. The intelligent investor is astute and prudent, always seeking to outperform in preference to achieving average.