Don't Be A Market Cinderella

By David McEwen

Monday 21st May 2001

Do you know the difference between investment and speculation?

One of the best descriptions of the chasm that separates the two wealth creation activities comes from Warren Buffett, the US-based man who has made billions from the share market.

He says speculators tend to act like Cinderella at the ball.

"They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party.

"Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands."

The point he makes is that speculators buy with the express intention of selling, preferably in as short a time as possible, at a whopping profit. The flaw in this plan is that they require someone equally as greedy and presumably less intelligent to buy from them at the new inflated price. This is often referred to as the 'greater fool' theory.

Such buyers are not hard to find when the market is raging and prices are rising steadily. However, they are extremely hard to locate when the market starts to dip - as all those who bought technology shares at outrageous prices found to their cost last year.

Many people are aware that the market tends to go wild during the boom times but most think they have enough talent to know when a crash is coming. They intend to get out before that happens. History has proven that almost everyone overestimates their abilities in this regard.

Investors are more likely to be compared with another fairytale character, Sleeping Beauty. They buy a company they like, generally at a price lower than its value, and hold that investment until it is unable to maintain superior returns for the foreseeable future.

As Warren Buffett says, the best time to sell a good company is never. If it is a good company that produces superior returns year after year, why would anyone want to sell it? The concept of 'taking profits' is anathema to him because he understands that real wealth comes from compounding returns over a long period.

Here are a few tips to make sure you become a Sleeping Beauty rather than a Cinderella.

(a) Remember that you are not buying shares but part-ownership of a company. Imagine you own the whole company, how would that change your perspective?

(b) Have firm guidelines for what constitutes a 'buy' or 'sell' situation - chances are 'rumours' or 'what everyone else is doing' won't be on such a list.

(c) Don't try and time your market entries and exits. As the cliché says, it's time, not timing, that delivers share market success.

(d) Once you have bought, focus on the company's financial performance rather than its share price.

(e) Make your perception of 'short-term' stretch to several years, rather than mere months.

Finally, I would encourage investors always to keep in mind that there is a difference between price and value. One is what you pay; the other is what you get.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

Comments from our readers

No comments yet