[updated on 11/21/2013 with additional text; on 7/30/2014 with a counterargument; updated on 10/18/2016 with additional text and revised title]
AXIOM #1: Markets are a human necessity. corollary: There will always be a volatile stock market.
AXIOM #2: The most basic stock-investment strategy is to buy shares at a discount price and sell them at a premium price. In other words, buy ‘low’ and sell ‘high’. corollary: Buy shares that are in ‘low demand’ and sell those in ‘high demand’. The share price will increase with demand. This is the fundamental principle of “Contrarian” investing.
AXIOM #3: Good companies attract investors.
AXIOM #4: Good companies reward investors.
Capitalism 101: Companies sell common shares of stock to raise money for their businesses. Investors buy the stocks in order to share the business profits. The first-generation investors are venture capitalists in the primary market who aim to resell their shares to second-generation investors in the secondary market. Second-generation investors hope to earn dividends from the company’s profits and capital gains from stock sales in the marketplace. Capital gains are earned by selling stocks at a higher value than the total cost of purchase. The stock market price is governed by forces of supply-and-demand.
After the companies are financed, why should they care about the shareholders? Because common shareholders are beneficial owners who have the right to 1) vote on issues of governance, 2) seek rewards, and 3) seek damages. Shareholders also provide a measure of crowd-protection from hostile takeover of the company.
Good companies reward investors by paying dividends and/or raising the value of tradable shares (e.g., issuing stock splits, repurchasing shares, growing the business). These rewards are endangered by stock price fluctuations, declining business profits, corporate greed, and additional uncertainties.
The buy ‘low’ and sell ‘high’ strategy is difficult to practice in times of financial panic when investors lose interest and tend to pull out of plunging markets. At the very moment when their prospect for future returns is highest, investors are out of the market 1,2.
- Buttonwood: No easy answers | The conundrum of asset allocation. Jul 19th 2014. The Economist
- William Bernstein, Rational Expectations: Asset Allocation for Investing Adults. 2014.