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But what if shares crash? Understanding the difference between share price and value

In the financial media, there is a focus on explaining short term fluctuations in share price. Commentators often try to attribute every little rise and fall to a particular event or issue.



Perhaps the most common factor holding a novice investor back from achieving a great return is a misunderstanding of what happens when markets fall (as they invariably do!).
 
In order to address this, one would be well served to go back to basics and consider the following three principles: 
 
  • A share is simply a small slice of company ownership;  
  • A company’s value ultimately depends upon its present and future cash profits it can generate;
  • value may not always equal price.
 
Multi-billionaire and one of the world’s most successful investors, Warren Buffett, has defined investment as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.”
 
In other words, it requires patience. Buying a stock (or house, managed fund or any other asset) and simply hoping the price goes up soon is, most certainly, not investing. While we may naturally feel emotions based on what the price does over the short term, history has shown it is vital not to let emotions steer our financial decisions.
 
The focus should be on the quality of the underlying business
 
A share is simply a slice of ownership in a business. If you’ve started your own website, perhaps opened a restaurant, bought shares or even invested in a portfolio of businesses through a managed fund, you are now a business owner. For this reason, focus should be directed at the quality of your businesses and their prospects for the future, rather than a chart with a line that wiggles up and down as the price rises and falls.  
 
Unfortunately, in the financial media, there is a focus on explaining short term fluctuations in share price. Commentators often try to attribute every little rise and fall to a particular event or issue. The risk is that an investor may start taking their queues from price movements (which are driven by short term sentiment and emotion), rather than value (which is ultimately driven by the cash flows a business generates now and into the future).
 
Benjamin Graham, often known as the ‘father of value investing’, famously said that "Price is what you pay, value is what you get." While the price of a share will certainly fluctuate, (sometimes multiple times per second, every day of the year), the value of a company’s future cash flows is likely to be considerably less volatile. 
 
Speculation; i.e. buying and hoping that a price will go up soon, might be considered the antithesis of investing, and shouldn’t be considered a safe strategy to build long term wealth. Mark Twain once aptly mused that, “October is one of the most dangerous months to speculate in shares. The others are July, January, September, April, November, May, March, June, December, August and February.”

Share price volatility 
 
If a share price falls sharply, yet the value of the business’s future cash profits doesn’t change, this may provide an opportunity to purchase further shares at a discounted price, hence maximising the potential return and reducing the potential for loss. A skilled investor may apply this principle to a portfolio of businesses in order to further reduce risk to the investor through diversification.
 
Therefore, good investors tend to regard significant share price falls as potentially attractive buying opportunities. Volatility is the friend of the long-term investor.
 
That is not to say share price volatility doesn’t matter. For example, self-funded retirees being forced into selling shares at temporarily reduced prices in order to fund their lifestyle isn’t an attractive proposition. For this reason, financial planners commonly emphasise the importance of maintaining an adequate cash reserve - particularly in retirement. 
 
Whether you are invested in a managed fund, direct shares or an investment property, price matters at precisely two times - when you buy and when you sell. Your return on an investment depends on these prices and the distributions you receive over the investment period.  
 
For these reasons, the best investors will tend to remain focused on the fundamental prospects of the underlying companies owned, and think as business owners - making share price volatility a friend, not foe. 
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