Global stock earnings have fallen by more than 40%; yet, the Nasdaq Composite, and S&P 500 have reached record highs since the pandemic first crumbled market security around the world. “The Market is never wrong” saying from an introductory economics course (efficient market hypothesis) will seem at odds with these two seemingly contradicting realities — a simple question to ask is why are stock market investors so confidently betting on companies reporting poor earnings? More importantly how will this impact the future of our economic stability?
To answer these questions we must first examine the 3 main investing strategies used to approach today’s stock market:
The “Warren Buffett Way”, also known as value-investing, is most traditional and by many measures — the most safe. The simple idea is that you should invest in stocks whose value is lower than it is priced at. While this method is low risk, the return generally isn’t as high as other strategies. Measuring the value of a stock can be as simple or as complex as the investor wishes to investigate. Looking at the earnings to stock price ratio, the volatility index, and the beta will give investors a rudimentary understanding of where the company is. Interestingly enough however, the current market doesn’t seem to reflect this notion. Most investors may be resorting to other strategies.
Among these strategies is quantitative investing, used by investors making decisions on complex mathematical models (D.E & Shaw, Two Sigma, AQR Capital, etc.). They utilize “sophisticated” algorithms to analyze the up and down trends in the market to predict its next move. The problem with this method is the danger of information network cascades (a phenomena describing “a number of people making the same decision in a sequential fashion,” very similar to the herding effect). This can be very dangerous if the initial assumption of information is incorrect; then, everyone is incorrect and the market is overvalued and extremely risky.
Thirdly, there is small cap investing. While these stocks have a potential for high growth they also carry the highest risk. These companies valued in the $300 - $500 million range, small time for a company that is publicly traded. Because they are on the smaller side, they are also more commonly overlooked by the majority of investors. Historically speaking, this is true for stable economic times. During recessions however, history has shown that these risker companies are more likely to attract financial capital from investors.
In the brief descriptions of these three types of investing, we can notice the potential risks and rewards that they may pose. Value investing can be too conservative depending on your risk tolerance. Quantitative investing is efficient, but dangerously risky if the initial assumption of information is incorrect. Small cap investing is similarly a high risk, high reward/loss game.
It's an important step in financial literacy to be able to recognize their nuances. The more you are aware of these strategies the less you can be swayed by false information and achieve greater independence financially as well as personally. At Building Blocks for Kids, we do not only educate students about the facts of finance, we equip them with a deductive, practical framework useful in making thoroughly investigated financial and career decisions.
Sources:
https://www.investopedia.com/articles/stocks/12/most-shocking-stock-increases-falls.asp https://en.wikipedia.org/wiki/Information_cascade
https://www.moneycrashers.com/types-stock-market-investment-strategies/