72 ATaleofTwoMarkets
use market prices as a metric in valuing a business. That gets the
process backward. Market price is thelastthing an investor should
loo kat in a valuation exercise. All the mar ket price tells you is what
you can buy (or sell) a share of stoc kfor.
The market does not at all tell you whether that is a good or bad
deal. Answering that question requires conducting a valuation based
on the fundamental business and economic characteristics of the is-
suing company. These are the tools considered in the rest of this book.
In using these tools, all investors—institutional and individual—
also should appreciate a few other implications of market complexity
that follow from the question suggested at the beginning of this
chapter: What does a stoc kmar ket’s four-year cycle length mean? It
certainly means that the most revolutionary investing ideas of the
last 30 years—EMT, MPT, and CAPM—can be misleading.
These are the lessons to relearn:
- It is not a waste of time to study individual investment opportu-
nities in stocks. - You are likely to do better by thinking about whether individual
investment opportunities make sense than by randomly selecting
a group of stocks for a portfolio by throwing darts at the stock
tables (as contests sponsored by publications such asThe Wall
Street Journallead many to believe). - Nor will you do better by using modern portfolio theory’s strategy
of putting your eggs in lots of different baskets based on whatβ
tells you the ris kof each bas ket is.
It should also be noted that one of the costliest lessons of mod-
ern finance theory was the proliferation of portfolio insurance—a
computerized technique for readjusting a portfolio in declining mar-
kets. The widespread use of portfolio insurance helped precipitate
the stock market crash of October 1987 as well as the market break
of October 1989, for the models prescribed selling off blocks of stock
as their prices fell.
That massive an error—on the scale of the entire market and its
participants—suggests that similar errors occurred throughout the
investing population, including missed opportunities for gain by
small investors. Accordingly, you should ignore modern finance the-
ory and other quasi-sophisticated views of the market and stick to
investment knitting.