Let's get this straight: the price of a stock is not random*. The price is (theoretically) all future earnings of a company discounted at some rate (depending on the risk of the stock) to the present day. What this means is that in order for you to rationally price a stock, you first want to see what money it will deliver to you in the future, and how likely it is to deliver that money. The more earnings and/or the more likely it is to achieve those earnings, the higher the price. So, to price a stock, you form your expectations about all future earnings and discount them depending on the risk of the stock to today's money, and now you can rationally decide if a stock is a buy or sell or even short. This whole thing is called the Discounted Cash Flow Model.
Now, this is the essence of this post: a change in expectations about future earnings, or a change in the discount rate are the only things that change investor sentiment about a stock. It is not how it has historically performed nor about its current situation. It is always how do investors feel about the future of the company.
A lot of people on this sub like that point out the history of a stock to jusifity going long, or the fact that the company is projected to make a lot of money or that it currently does. The reality is that all of that is reflected in the price of the stock. You can use historical earnings to project future earnings, but that is all, and those future earnings are already reflected in the stock's price. Only a change in expectations or the risk of a company meeting expectations influence the price of the stock. This ultimately means only future events can change the price of the stock, and unless you can predict the future, for all intents and purposes, the price of a stock today is right.
Here's a consequence of this line of thinking:
You want to know why Apple is $2.1T in market cap? It is a mix of high earnings in the future and a very low risk of missing.
Have low risk necessarily means having lower future returns. Almost all (>97%) returns are explained by taking on more risk (using the Fama-French 5 factor model). This is the fundamental idea behind investing, and is basically a law at this point. High risk = high reward.
Apple being priced high means that it's expectations are high (meaning for anyone who invests in Apple right now, they are expecting Apple to earn lots of money) and those expectations are not terribly risky. This ultimately means that for Apple investors to make returns at or above the market, Apple has to consistently beat expectations and become even a safer investment in order for current investors to make returns.
What this ultimately means is that in the long-term, large cap growth stocks are not the best investments you should have. Companies like Apple are basically guaranteeing you low returns in the long run. If you have a long time horizon, you should be investing in systematically risky assets because in the long run, you make more returns. Things like value, and small cap stocks are higher risk and higher reward.
*Price movements are a random walk, but that is because the future is effectively random.
Submitted August 28, 2020 at 07:43PM by MrMineHeads https://ift.tt/2YEBNEH
