In the real world, the stock-market price of a company is often at least somewhat different to what a mathematician might expect based on a reading of the company’s financial statements. The reason for this is that although the ability to do basic maths is usually a prerequisite to having a successful career as an investor, most successful investors go beyond purely mathematical stock-picking models and make extensive use of human judgement as well.
The human factor
Successful investors will often look at factors which simply can’t be captured mathematically. For example, they may look at the perceived quality (and/or popularity) of a company’s management, developments in its industry niche (and where the company stands in relation to them) and the potential impact of government actions (or lack thereof). Although this process should be entirely rational and objective, the fact that investors are only human means that it is almost inevitable that sentiment will creep in, at least from time to time. At an individual level, this will not necessarily make a noticeable difference to a company’s share price (although it can do if the individual in question is a high-net-worth investor with a significant stake in a company and/or a significant presence across the broader stock market), but if large numbers of people are being driven by a similar sentiment, for example as a result of broader macroeconomic factors (like Brexit, for example), then it can push a company’s share price far higher or lower than its financial data warrants, at least for a short period of time (until sentiment changes). In fact, if the level of sentiment is strong enough, then it can influence entire share indices and send them trending upwards or downwards.
To trend or not to trend, that is the new investment question
It has long been widely acknowledged that market sentiment can influence share prices, both individually and collectively. According to traditional wisdom, however, astute investors ignore the “froth” of emotional reactions and focus on finding and holding companies with solid fundamentals which can generate meaningful returns over the long term. The Oracle of Omaha, Warren Buffett himself, maybe the epitome of buy-and-hold investing and, as such, a powerful symbol of just how well it can succeed.
Without detracting from Buffett’s many achievements or his status as a legendary investor, times change and a strategy which was appropriate for one era may become outdated in the next. Even though buy-and-hold investment strategies are likely to be the bread-and-butter approach of most investors most of the time long into the foreseeable future, some modern investors are now suggesting that it makes sense to combine this approach with trend-based investing in recognition of the fact that emotion is, or at least sometimes can be, a meaningful market force.
According to these investors, markets which are on a clear upward trend tend to be markets in which there is very little volatility. Basically, the rising tide floats all boats with the result that most investments perform at least decently well and so most investors are reasonably happy, at least happy enough not to feel that they need to sell and certainly not in a panic. By contrast, when a market is on a clear downward trend, there is likely to be a lot of volatility as some people sell in a panic, depressing prices, while others see the situation like a fire sale and go on a buying spree, sending them upwards again. The idea behind trend-based investing is not to try and time the peaks and troughs of the market but to recognize when a market is moving from an upward trend to a downward trend (and vice versa) and adjust a portfolio accordingly. Typically this will mean being predominantly invested in equities when a market is rising and predominantly invested in bonds when it is falling.