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It is interesting that we don't think about shares in the same way that we think about other things that we buy or use. While it may seem strange to compare shares to mangoes, let's take a stab at it anyway.
Mangoes, just like other fruit and veg have a pricing cycle. Mangoes are cheaper at some times of the year compared to others. During the cheaper times, they are in season, they usually taste better and we happily buy more of them. When they go out of season, they become more expensive, a bit manky and we don't touch them.
While company share prices are not driven simply by supply, we seem to like them more when they are expensive rather than when they are cheap. Many average investors seem to have this weird habit of buying shares after a few years of rising prices – when they are expensive. These same investors then tend to become fearful of shares and sell them after their price has fallen – when they are cheap.
The companies that make up the bulk of the value of the Australian share market index (the ASX 200) are essentially the same during the expensive times as they are during the cheap times. During the four months to 11 August, 2011 the price of BHP Billiton shares has been as high as $50 and as low as $35, but during that period the company itself was largely unchanged. You certainly can't legitimately argue that at one point during the last four months, BHP was worth nearly 40% more than it is now. Part of the problem is that we sometimes equate 'price' to equal 'value'.
It is clear that share prices move as a result of many other things beyond intrinsic value, but if you are buying shares to hold long term then these short-term elements may lose a lot of relevance.
One way to look at investing in shares is to treat them like mangoes. Shares are real (even if you can't eat them) in that they represent a piece of a real business doing real things. Once you start to ignore all the hype, then the idea of buying them when they are cheap starts to make more sense.
Of course, individual companies can and do go broke. When that happens, the owners of the shares (owners of the company) lose all the value that they had invested in that company's shares. To reduce this risk, most superannuation funds invest in a wide range of different companies. Even if one company does go broke, the overall impact to a well diversified share portfolio should not be too dramatic.
When we see market volatility like we have seen over the last few weeks, we are looking at events that drive changes in the short term value of the entire market. In that same four months mentioned above, the ASX 200 went from 4,976 to 3,765 – a movement of over 30%.
The downgrading of the USA from AAA to AA+, on the face of it should not impact the underlying value of the companies that make up the Australian sharemarket. But the market sentiment – call it confidence or lack thereof – does change the price. The price changes because poor market confidence leads to people selling and when there are more sellers than buyers, the price goes down. It doesn't necessarily change the fundamental value of those companies.
The question that we should be asking is: does this new price level reflect a fundamental shift in the value of these companies? The ability of these companies to continue operating, provide services and products, employ people, and generate profits. If the answer is "No" then we have an opportunity – to make a decision on buying, holding or selling based on the reality of the value of those shares rather than market sentiment.