economonkey

If you can keep your head while all around you are losing theirs, you’d probably make a good investor.

Times of turbulence on stock markets can be times of opportunity for the savvy investor. Picture the scene last week. City traders losing X billion pounds a day and having to cancel the order for that third gold-plated Porsche. Pension fund managers taking one look at their huge losses and… shrugging because it’s not their money. Uninformed media sources proclaiming the end of the world. Meanwhile, you could have been quietly sitting at your computer, raking in the cash.

Most people are aware that to be successful at investing you should buy low and sell high. What fewer people know is that you don’t have to do it in that order.

Buying low and selling high means that you are ‘long’ a particular entity. For example, if you buy shares in Skullcrusher’s Friendly Bailiff Debt Grabbers Plc at a price of 10p, in the expectation that they’ll reach 50p on the back of increasing debt defaults, you are long that trade.

But you could also sell high and buy low. If you think Skullcrusher doesn’t have much of a future because there’s no money left to collect, you could short the trade; borrowing the shares, selling them at 10p and hoping to buy them back at 2p, for example. In this case you would be short Skullcrusher Plc.

Prices only go up, don’t they?

The title of this article combines comments by Alan Greenspan about the stock market boom of the 1990s (”irrational exuberance”) and the title of a book by Charles Mackay. The book, “Extraordinary Popular Delusions and the Madness of Crowds”, is a short but interesting one, covering those aspects of human psychology, sociology and politics that lead to what are known as bubbles. A bubble is loosely defined as what happens when the price of a particular class of item breaks away from fundamentals and, in effect, goes up because everyone expects it to go up.

We’ll rewind a bit here and take a look at the way markets usually work; all markets, not just financial ones. Company A produces a product; it could be a car, a toaster, a cake or a life insurance policy. In order to sell its product, Company A must price it at a realistic point. Too low and it will lose money on each product it sells. Too high and nobody will buy it except the rich and the insane (often the same demographic).

Note that to keep it simple here I’m excluding things like loss-leader promotions, where products are deliberately sold below cost to stimulate demand for related items.

Anyway, in a stable market the price is set at the margins, where the ability and willingness of the buyer to buy is matched by the ability and willingness of the seller to sell. This is a nice little negative feedback loop that keeps prices competitive, assuming competition is permitted within this particular market sector. Shortages of supply - whether real or deliberately created by withholding stock - can lead to increases in price, but higher prices will only be met if the demand is present and if Company A isn’t undercut by Company B.

And, most crucially of all, demand is moderated by the ability to pay. As the old example goes, the demand for Ferraris among 12-year-old boys is pretty much infinite, but that doesn’t have any effect on the market (at least until they grow up) because they have no ability to pay.