The Stock Market is a Lot Like Baseball

The stock market has always amazed me. It's such an integral part of our economy, our jobs and our financial futures yet the average person has very little knowledge as to how it functions. You would think that such an important aspect of our daily lives would have been taught to us in school, yet we walk away with only basic economic concepts.

The underlying fact is that because so many people know little about it, investing can be a daunting and in the case of Madoff, be a harmful experience. So much relies upon what we have already accumulated, yet we still aren't where we want to be. Understanding the stock market and how it functions can help us make investment decisions with a little more confidence.

The stock market can be compared to the World Series. There are two teams, announcers, an audience and a whole bunch of other components that really tie the two together concepts together in similarities.

In the stock market there are buyers and sellers, these can be likened to the two teams playing. There are two teams playing against each other and only one will win. The fundamental truth here is that in order to buy a stock, someone has to sell it to you. That means that the person selling it to you thinks no more economic value will be extracted from it while you think there is still potential. One of you is wrong.

Another component in the stock market is mutual funds. Mutual funds are the employees who work in the back office for the championship team. They'll get a ring if their team wins, but their bonus is never as big as the players themselves.

The audience can be likened to index funds, they're just there to watch be at the game and win over time just for being there. However, they don't really see any immediate benefit besides exposure to the game.

The announcers are like Wall Street, calling the play by play and reporting on recent happenings. They sway between excitement to lethargy depending on what is happening in the moment. However, as knowledgeable as they may seem, they cannot be relied upon to accurately predict the long term outcome. The only thing they do is broadcast and sometimes point out arbitrary facts.

Now that all the basic components of the stock market have been described, we need to talk about the game itself. Now while a typical World Series game lasts nine innings, the stock market world series is game that doesn't end. So how is a winner determined? The winner is determined depending upon the individual time horizon of the players on each team.

So if you are buying Procter & Gamble for a long term investment and it drops in the short term, you haven't lost the game yet until your time horizon has been reached. This allows there to be multiple winners and losers all simultaneously, making the game a little more fair to the participants involved.

Also, unlike the World Series where only one game is played at a time, there are many games being played all at once in the stock market depending upon what stock you are talking about. Each stock has its own game being played. So there is the Johnson & Johnson game being played along side the Procter & Gamble game and so on and so forth. As an investor, you will find yourself playing in different games on all different teams depending upon the position you've taken in your portfolio. Some you may feel are going to be winners making you a buyer, while some you may feel is going nowhere or down, making you a seller (or even a short).

This sort of competitive play goes on in all the different markets associated with the stock markets (derivatives, CDS's, futures, etc.) and it is up to you as an investor to decide what games you want to be in and what your role is going to be. Are you a player, a back office manager, or an audience member? It depends upon your strengths and comfort level in the games you are a part of.

(This article originally posted on April 19th, 2010 on Technorati. Read the original article here.)

Benjamin Graham Was Wrong

I was doing some equities research and I ran across this from Benjamin Graham's classic 1934 edition of Security Analysis:

This was one of Ben Graham's examples of calculating the Net Current Asset value for a stock, by using a discount rate to calculate the true liquidation value of various types of assets on the balance sheet. The only thing is that Ben Graham's White Motor Company example was actually incorrect.

If you look at the liquidation value of the Total Current Assets, he only subtracts Current Liabilities to arrive at the Net Current Assets Result of $16,300 when in fact he should of subtracted Total Liabilities.

In practice, if a company goes bankrupt, all creditors go to the front of the line because the assets are collateralized by debt. That would mean that ALL creditors go to the front of the line, not just the ones who are due in one year or less. If long term creditors were left out, how would they receive their repayment if the shareholders got what's left way before the creditor's debt needed to be serviced?

The answer is it would never happen. That would be the equivalent of the owners of a house in foreclosure receiving the rest of the sale price of the house after only the first year of debt had been paid for on a 30 year mortgage. What about the other 29 years worth of money the bank forked up so the owners could buy the house? The same is true for a company. The long term creditors are due their piece of the pie and will always get theirs well before the shareholder even see the leftovers.

The funny thing is that Benjamin Graham knew this and stated on the page before this example:

"The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score."

However, its clear in the example that he only deducted current liabilities. Perhaps this was just a flub up, but the conclusions he derives are based upon the erroneous fact of subtracting current liabilities. The funny thing is that people like Buffet, Ruane, and Graham himself based the majority of their investing decisions on this calculation when it is in fact wrong. Talk about luck!