What is the best way of understanding how investments work? originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.
The market environment is the result of the relationship between asset prices and their underlying intrinsic values. Generally speaking (and with exceptions for non-corporate assets such as real estate and timber), the market prices for assets are the result of two things: fundamental developments and people's reaction to them.
What I call "fundamental developments" include the performance of the economy, the performance (including the expected performance) of the companies that issue securities, and exogenous developments that are unrelated to the issuing companies but which have impact on the market. The later range from weather to elections to acts of war.
"Reactions to fundamental developments" refer to how people feel about the things that are taking place. Developments influence how people feel, and people's feelings influence how events are incorporated in security prices.
In general, favorable developments make assets worth more: they increase the intrinsic value. Thus strong economic numbers, strong profits announcement from a company or the subsidence of global tensions all make the company's stock and bonds worth more.
Apart from increasing the intrinsic value of assets, positive developments make people feel better about them, too. Positive developments tend to make people more optimistic, less fearful, more believing and less risk-averse.
So if we take these things together, we can see them interact. When a company is expected to earn $1 of profit for each share it has outstanding ("earning per share," or e.p.s.), its stock might be priced at $15. But if the sum of strong profit reports and an improved profit outlook make it appear the company might have e.p.s. of $2 a year from now, (a) the higher e.p.s. taken alone imply a higher value and (b) more-positive emotion might make people value those e.p.s. higher. So rather than double on doubled e.p.s., the stock price might triple (this is an extreme example).
Lastly, the trend of security prices themselves can have a positive "feedback" effect on emotions. So positive emotions cause securities to appreciate, and rising security prices might make people feel better about things, causing prices to appreciate further. Of course, an objective onlooker might consider this "compounding of enthusiasm" as excessive.
The bottom line is that the investment environment is shaped by fundamental developments, emotion, and the impact of market performance on emotion. When emotion is positive and market gains are reinforcing that emotion, it's likely that stocks will be expensive, prospective returns will be below average, and risk will be high. This is the time for defense (and vice versa).
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